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Busting the Biggest Dividend Myth

Myth: when a company chooses to pay dividends, it does so at the expense of future growth.

I’m here to tell you that myth is absolutely false.

It's possible to get growth and income in one investment. Not only that, it's more likely that you’ll generate a higher total return from companies that make dividends a priority. It might seem counter-intuitive – but it’s absolutely the case.

I know from experience.

The High Yield Wealth portfolio includes a number of recommendations that have produced both exceptional income and impressive capital gains for investors.

Textainer Group Holdings (NYSE: TGH) is one of many examples.   

Over the past five years, this shipping container leasing company has grown revenue at an annual average rate of 14%. In 2012, the company raked in sales of $487 million. Over the same period, EPS has grown 19% annually to $3.96. 

Textainer consistently grows its business, and continues to pay 40% to 50% of its income to shareholders. Each year the dividend grew and the yield remained healthy at around 5%.

Of course, total investment return is the most important measure of investing success. Over the same five-year period, Textainer shares have delivered 22% average gains.

Not surprisingly, the stock has gained 25% since we recommended the company to our High Yield Wealth subscribers just eight months ago.

My experience with Textainer isn't all that unusual. And this is why I rarely think in terms of growth versus income. The good news is there is a wealth of research that supports my experiences.

An influential article titled “Surprise Higher Dividends = Higher Earnings Growth,” appeared 10 years ago in the Financial Analysts Journal. The article's authors, Robert Arnott and Clifford Asness, advance a thesis with which I'm somewhat familiar: dividends focus the mind.

When a company pays dividends, it prevents excess capital from accumulating. The problem with excess capital is that it's frequently allocated to ventures that generate diminishing returns. On the margin, these new ventures are simply less profitable than previous ventures.  And in the worst-case scenario, these expenditures become loss-leaders, turning cash in the bank into a continued expense.

Paying a dividend forces the executives to focus on the most profitable, highest-growth ventures. N contrast, not paying a dividend frequently leads to inefficient empire building, with lower returns to investors being the end result. 

The notion that dividends – and especially dividend growth – can foreshadow exceptional earnings growth actually predates Arnott and Asness. I've read similar accounts expounded by the great value investor Benjamin Graham. 

I'd first crossed paths with Graham's dividend-paying thesis at the start of my investing career, after reading a series of published lectures he gave in 1946.

In these talks, Graham mentions that he consistently agitates for dividends in order to keep management focused on maintaining high returns on invested capital. Like Arnott and Asness, Graham knew that unrestrained capital accumulation led to lower future returns. 

The High Yield Wealth portfolio has many investments that pass through much of their earnings to investors.

They can do so because they have a record of business success, which allows them to tap external debt and equity markets on favorable terms. 

Equity and debt markets are tapped, new capital is put to work in profitably, and the business grows. It's that simple.   

That’s why the share price of these dividend growers continues to also rise, right alongside the dividend. It’s for this simple reason that dividend growers are among my favorite income investments – making them far preferable to just “high yield stocks.”