So you have finally decided to take the plunge. You have set aside money to invest in the share market so now comes the fun part, which shares should you invest in?
The name of the game when investing in shares is generating a positive return on your money and of course the return needs to be better than just plonking your money in a bank account. Otherwise why bother to take on the extra risk?
Returns from shares can be generated in two ways: from income in the form of dividends, or from a growing company share price.
Of course the two are not mutually exclusive, many companies aim to deliver a mixture of both for their shareholders. Personally these are my favourites and I will talk more about them later.
Income stocks
A company is referred to as an income stock if it pays regular dividends which hopefully grow over time. A company's dividend yield, is calculated by dividing the full year dividend by the current share price. The historical average yield for Australian companies is around 4.1%. Interestingly the US stock market long term yield is considerably lower at close to 3%. (It is currently sitting at 2.4%).
Income stocks tend to be well established companies with a regular cash flow from a mature client base enabling them to pay dividends. Another consideration for those deciding to invest in income stocks is franking credits. Franking credits are where the investor receives a tax credit for any tax the company has already paid on the dividend.
The downside for those investing in income stocks is generally lower share price growth. Telstra Corporation Ltd (ASX: TLS) and the Commonwealth Bank of Australia (ASX: CBA) are good examples; while the dividend yield is higher than the market average, their future growth prospects look modest.
Growth stocks
As you have probably guessed, the idea behind investing in growing companies is to benefit from share price rises. The share price of a rapidly growing company can be more volatile as the market tries to assign a price to its future plans. A good example of this type of company on the ASX would be XERO FPO NZX (ASX: XRO), which is aggressively spending on software improvements and marketing to capture market share.
The CEO of XERO has gone on record to say that he could turn off marketing expenditure and pay a dividend today, but he believes it is not in the best interests of the shareholders at this time.
This brings us to an important concept, the company life cycle.
Company life cycle – growth then dividends
Every company when it starts out will need to spend money to make money. It needs to be prepared to fight for its market share and fight to defend its market.
One of the best examples of a successful or full company life cycle is Microsoft Corp. In its early years all profits were ploughed back into the company to improve its product (Windows) and chase market share. Only when Microsoft had gained a monopolistic position in the market and growth prospects had slowed, did it then start paying dividends to its shareholders.
So what shares should you buy?
The choice between growth and income investing is very much related to each investor's individual circumstances.
Younger investors with time on their side can look for growing companies, while retired investors may require income companies to provide money to live on.
Personally, I look for growing companies that are paying a dividend.
Two of the my favourites are REA Group Limited (ASX:REA) and SEEK Limited (ASX:SEK). Currently both pay a small but growing dividend, while most of the profits are retained within the business for future expansion. My retirement plan is to hold both companies to enable me to sip champagne on a tropical beach thanks to their large juicy dividends that will be delivered long term.
Well I can dream, can't I?
