Tuesday, November 11, 2014

Capital Gains or Cash Flow?

       The average investor can investor for 2 things, which are capital gains or cash flow.

Capital Gain

      If you own a stock and hopes it goes up in value to sell it at a higher price.  When the investor sells at a higher price, that is considered a capital gain. If the investor sells the stock for less than what they paid for it, that would be considered a capital loss.  The thing with this type of investing, is that when you sell, you MUST go out and buy another asset.
      A good example of capital gain is the purchase of physical gold or silver.  These two investments do not yield any cash.  These investments must go up in value in order for the investor to make a profit when they sell. These precious metals are used sometimes by investors to hedge against the US dollar.
       When an investor owns a mutual fund or ETF, they might end up with a capital gain to report on their tax returns, even if they never sold any units of the mutual fund or ETF.  The reason for this is the mutual fund or ETF, might end up with a net capital gain for all their buy and sell transactions. The mutual fund or ETF pass this on to investor.

Cash Flow

         When an investor invests for cash flow, they want to get paid.  This payment of income can be interest, dividends, option premiums, or distributions. Interest payments come from bonds, bond ETFs or bond mutual fund. Dividends are payments that come from equity ownership in a company. Distributions is a form of payment that can come from things such REITs, mutual funds, and ETFs. Option premiums are paid to the sellers of options up front.
        Depending on the form of payment, the tax treatment of the income varies.  A payment of interest is taxed as ordinary income, or at your marginal tax rate. Dividends can be taxed differently depending on a couple of things.  For Canadians, if they own a Canadian company's stock, the dividend will be taxed more efficiently than interest income.  If Canadians own a foreign stock, the dividend is taxed the same as interest income.  When distributions are paid out, the payments can consist of interest, dividends, capital gains, and return of capital.
          Option premiums that are collected are basically capital gains. I am not going to get into options here as it can be more complex than the other types of cash flow.

 Capital Gains or Cash Flow? What is better?
  
         For me, I invest for cash flow mostly. Every month or quarter, I receive a payment. If I do not sell the position, that asset will continue to pay me unless the company, fund or ETF's stop paying dividends, distributions or interest. I will use stock ownership as an example here. Some companies will increase their dividend over time.  These increases are usually higher than the rate of inflation.  I can choose to do what ever I want with these payments. When the cash flow from my investments are greater than my expenses, then I will be be out of the rat race and financially free.
       For capital gains, I trade a stock or option in the hopes of making a profit. I then have to turn around and purchase another position, buy an option, or sell an option.
        A good example of dividend growth investing is Grace Groner. Grace bought 3 shares of Abbott Laboratories in 1935 and reinvested all the dividends.  With capital appreciation, dividend increases and stock splits, this investment grew to over 7 million dollars. You can read about Grace Groner here.
  
Note: Currently,  I sell put options only on stocks I want to own at a lower price. The option premium I receive is a way to make money why waiting to see if the stock falls in value or not. If the stock does not fall below the strike price, I let the option expire. I get to keep the option premium.

DISCLAIMER
     I am not a financial planner, financial advisor, accountant or tax attorney. The information on this blog represents my own thoughts and opinions and should NOT be taken as investment or business advice.  Every individual should do their due diligence to make their own financial decisions based on their financial situation and tolerance for risk

6 comments:

  1. I like both cash flow and capital appreciation. I don't have any preference over one or the other. But it does depend on my life situation. For example if I was unemployed or retired I would shift my investments to create more cash flow. But I am currently working and my job provides me with adequate income to pay for all my living expenses, so I take a more balanced investment approach of having dividends, interest, and capital appreciation :)

    ReplyDelete
    Replies
    1. Liquid,

      It depends on the investment for me. I have owned shares in BPF.UN since Mar 2010. My average price is around @12.46. My original purchase price was I believe 11.96 but I acquired 19 shares when I had the DRIP turned on. I continue to hold this investment has it is a royalty fund with little overhead. Royalties come from gross sales, so everytime someone buys something there the fund makes money right away. Currently they are buying back shares, so they have not raised the distribution payment in about a year and a half.
      If you buy a stock at a good value, you can also hold it for a while. When you feel it is overvalued than you sell while collecting the dividends when they were paid out. This is a strategy that I have not used yet, but might try it in the furture.

      Delete
  2. I'll respectfully disagree that its an either or choice. A lot of income investors believe they cannot get capital gains. That its too hard or too risky so go with cap gains.
    Cap gains investors believe dividends are just an extra bonus but not worth going for as a primary goal.

    Historically if the market has returned 8% a year with div yields being 2.5%-3% then you are looking at 25% of total return coming from dividends. The cap gain investors avoiding dividends because they believe that "dividends proves a company is out of ideas" is missing out on an edge over the indexes.

    But likewise the dividend investor going for only the aristocrat blue chips will never get a deep discounted stock. JNJ. KO. and PG will never be at a huge sale barring a 2008 event.

    You can get both if one is choosy and patient. I think most dividend investors go with a shotgun approach where they fire off a buy and it hits a wide area...they end up with 30-50 companies that they cannot possibly keep track of and essentially just turn themselves into an index fund.

    ReplyDelete
    Replies
    1. Pullingmyselfup,

      I do agree with you when you, "You can get both if one is choosy and patient". Most amateur investors buy a stock and do very little research on it. I am guilty of that myself over the years. I do more research now, as I learned my lesson the hard way.
      With adequate research and decision to buy a particular stock, an investor has to choose a good entry point. For example, if an investor buys say 5 shares at KO at its 52 week high, it will take longer to achieve the capital gain they are looking for and/or the dividends they want. In the short term, KO has a better chance of going down then up.
      Buying the stock at a better price will improves your chances of success when it comes to dividends and/or capital gains. Aileron, Dividend Mantra, and yourself has proven this . I usually never use a market order as I have no access to markets while they are open. So I use limit orders to pick my entry points. Also, my broker is not set up to do what Capital Once does in the states with the $4.00 commission.

      Delete
  3. The Grace Groner story is awesome. I love cash-flow. I can handle a company not paying a dividend in the case like Berkshire because I know the money is being reinvested at a better return than most mortals could get. I also don't mind not getting a dividend in a company like Buffalo Wild Wings while it grows.

    ReplyDelete
    Replies
    1. DSF,

      Thanks for dropping by. A growing company needs the cash flow to grow at a quicker pace. If a company pays a dividend, then it slows down the process. I think your invested money is in excellent hands with Warren Buffett at the helm. It definitely more advantageous for Berkshire to not pay a dividend right now. I do believe has soon as Warren is not running the company, then they will pay a dividend shortly after his departure.

      Delete