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Why Do New Investors Focus on Capital Gains?

Investors I’ve talked to who’ve just started investing in the stock market tend to choose volatile stocks, which, more often than not, move up or down a lot in a very short time. Such stocks include marijuana, mining, or energy companies.

These investors think that dividend stocks are for retirees. After all, a good dividend typically yields ~4%. On a $1,000 investment, you’ll only get $40 a year. This is hardly a big enough incentive for these investors to stick around, given that they can buy low and sell high for a potentially higher gain than 4% in a shorter time.

But can they consistently book capital gains? If not, then focusing on capital gains or, shall we say, share price appreciation is not a viable strategy.

What drives share prices?

Bad news will likely drag down the share price of a company. Likewise, good news will likely boost the share price. In the short term, news drives share prices. In the long run, though, the fundamentals of a company will drive its share price.

Open Text Corp. (TSX:OTEX)(NASDAQ:OTEX) happens to be a dividend-growth stock that exhibits above-average growth potential. The company provides software and cloud services for more than 100,000 customers to manage enterprise information.

In fiscal 2017, which ended in June, Open Text generated sales of ~$2.3 billion, of which 41% were from outside the Americas. Having greater than $35 billion in annual customer spend, and which is a growing pie, the enterprise management information market is attractive. The company has been a consolidator in the space by making accretive acquisitions. Its return on equity has trended higher over the last five years.

software

An investment in Open Text from five years ago would have delivered annualized returns of ~27.7%. In other words, a $1,000 investment would have transformed into ~$3,328, with most of that coming from capital gains.

The share price appreciation had to do with a combination of the company experiencing good growth over the period and the stock’s multiple expanding from ~11.1 to ~16.5. All else being equal, the cheaper a multiple you pay, the higher returns you get.

Do growing dividends help drive share prices?

Open Text started paying a dividend in 2013 and has been growing it every year after that. Right now, its dividend yield is ~1.6%, which is below average. However, a growing dividend indicates that the company is doing well, which gives investors confidence and helps stabilize its share price.

Its quarterly dividend is 14.8% higher than it was a year ago. Furthermore, the company pays out about 20% of its earnings as dividends. Adding that the company has reasonable debt levels and is estimated to grow its earnings per share by ~17% per year for the next few years, Open Text’s dividend (and share price) should continue to grow.

Investor takeaway

A dividend-growth stock can deliver strong price appreciation as well. Both are driven by growing earnings or cash flows that depend on the execution of the company. Moreover, these stocks are safer investments than buying volatile marijuana, mining, or energy stocks and give you a better chance of making money in the long run.

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Fool contributor Kay Ng owns shares of Open Text. The Motley Fool owns shares of Open Text. Open Text is a recommendation of Stock Advisor Canada.

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