For many investors, a major factor in buying stocks is whether or not the stock pays a dividend. In fact, for many years this was such a key factor that I wouldn’t purchase the stock unless it paid one. There are many good reasons why investors would want to buy these stocks and keep them as a major part of your portfolio. But choosing to only invest in companies that pay dividends was my greatest mistake for many years.
One major advantage that goes to non-dividend-paying stocks has to do with taxes, especially in a taxable account. While there is a favourable income advantage that comes from Canadian dividend stocks, investors do not pay any taxes on non-dividend-payers until the stock is sold. That means that if you hold the stock for decades until retirement, you will not pay a penny of tax, allowing the stock to compound tax-free for all of those years.
Just take Shopify Inc. (TSX:SHOP)(NYSE:SHOP) and Amazon.com (NASDAQ:AMZN) for example. Early on I avoided both of these companies, primarily due to the fact that they did not possess a dividend. Given that each of these stocks has appreciated substantially over the past five years, with Shopify up 500% and Amazon up over 300%, I would have been far better off than focusing only on dividend stocks.
I remember buying both of them early on at pretty low prices, only to quickly sell them because I could not stand holding a stock that did not have a yield. I liked the business models, but could not stomach the very real possibility that the stock could fall and I could lose everything.
But the growth rates of these companies more than made up for the fears of a price collapse. Even though it missed expectations last quarter, Amazon’s revenues still grew by 29% year-over-year last quarter. Shopify’s were also spectacular, growing at a rate of 58%.
One further advantage is the fact that you are able to buy stocks from other countries that do not pay dividends and enjoy the tax-free status from them as well. Most countries, including the United States, have a hefty withholding tax on dividends. This makes owning these dividend stocks less attractive to own than Canadian dividend-payers when purchased in a taxable account or a TFSA. If the stocks do not pay a dividend, it doesn’t matter. You also get the capital gains tax credit when they are sold as an added benefit.
Finally, while the stocks do not pay a dividend themselves, you can create homemade dividends as you like in two main ways: using options or simply selling the stock. If you sell covered calls on your non-dividend payers, you can generate income that may even be greater than the dividend you would normally receive on a dividend paying stock. You can also receive the entire “dividend” upfront on your own schedule. Besides, options premiums are considered capital gains and are taxed as such.
If you do not want to deal with options, simply wait for your stocks to appreciate. If they rise a considerable amount, you can sell the stock and collect your “dividend” in the form of a capital gain. This income is taxed more favourably than dividends are in any case.
There are really only two downsides to the strategy of selling your stock. One problem is the fact that your stocks may go down rather than up. The second is the fact that some of your capital is returned to you along with the gain. Nevertheless, this is a tax-efficient strategy. If you’re patient, you’ll most likely find opportunities to sell at favourable times.
Owning non-dividend paying stocks is more volatile, so you have to have the fortitude to hold these companies during the downturns. But there are a number of advantages to owning these companies that may convince you to own more of these companies in your portfolio. Don’t make the same mistake I did. Don’t avoid companies simply because they lack a dividend.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Fool contributor Kris Knutson owns shares of Amazon. David Gardner owns shares of Amazon. Tom Gardner owns shares of Shopify. The Motley Fool owns shares of Amazon, Shopify, and Shopify. Shopify is a recommendation of Stock Advisor Canada.