Dividends are for growth, not just for income. Michael Clark looks at why long-term investors should never underestimate the power of dividends in generating returns
Growth investors, including those making plans for their retirement, can misunderstand, or at least underestimate, the importance of dividends in their investments. Dismissed as merely the icing on the cake, dividends are often overlooked in the pursuit of capital growth.
But there are reasons why growth investors should pay close attention to dividends and are at risk of sacrificing total return by ignoring them. Here are a few of those reasons.
First, is the powerful effect of long-term compounding of reinvested dividends. Reinvesting the dividends from investments can make all the difference to lacklustre capital returns. An investment in the FTSE 100 over the past 20 years would have returned 110% without the additional effect of dividends, but a more considerable 341% with reinvestment. Considering that dividend yields were under 4% for much of that period of time, it is clear that the small additional return from dividends makes a big difference over time.
Over the really long term, the difference dividends can make is spectacular. 'Triumph of the Optimists', a 2002 study of 101 years of investment returns, reckons that 92% of real returns from an investment made over 101 years is attributable to dividends.
The next point is, at a time like this, when shares are priced relatively cheaply, it is possible to lock-in a high yield and the possibility of capital return as well. Analysis of the last bull market from 2003 to 2007 suggests that buying high-yielding stocks can help overall returns. At the market's lowest point in March 2003, the average company in the MSCI UK Index yielded 4.8%. The 10 highest-yielding stocks in the MSCI UK Index at that time averaged a yield of 11.9%. As the market recovered from its March lows, those 10 highest-yielding stocks went on to post a capital gain of almost 91% over the next year. The average stock in the MSCI UK Index gained 49% over the year to 31 March 2004.
In addition, companies with a record of (or the potential to) growing their dividend tend to do better in growth terms. If company managements are growing their dividend, it is an indication that their prospects of business are generally good. Dividend growth can be seen as a robust indicator of a healthy company and research has shown that companies that consistently grow dividends tend to outperform the FTSE All Share Index.
Reliable dividend-paying companies seek to protect their dividend, even when times are tough or their share price is suffering short-term volatility. Regularly paying out, dividends can therefore smooth some of the volatility of investing in shares if they are maintained throughout volatile periods.
A big concern for investors at the moment is the recession eating into corporate earnings and hurting dividends. So a challenge for investors is to avoid the companies at risk of cutting their dividend. Certain sectors will suffer more than others as the pressure they feel from the recession will vary. For example, the proportion of European dividends from banks is expected to halve in 2009 compared with 2008 and at the same time, other sectors will increase their share of the market average.
Selecting the best payers
A successful equity income manager's approach should be designed to seek-out the best - note 'best' does not always mean highest - dividend payers. Even though many companies will have to cut or even abandon their dividend, I am confident that all the companies in my funds will be able to maintain, even grow their dividends, throughout the recession. In many cases, the companies have stated their intention to do so and my research validates their plans.
The dividend yield on the largest fund I manage, Income Plus, should be around 6% this year, well ahead of the yield on the FTSE All Share, now around 4.8%. In order to achieve that, we have focused on secure sectors: oil companies, pharmaceuticals, consumer staples, utilities, telecoms and supermarkets. We actually expect dividend growth from most of these companies, even in an environment of low economic growth.
Which makes another point about the value of dividends when recession bites. Accustomed to bull markets with shares rising at 15 or 20% a year some growth investors' perception of dividends is that they are nothing more than a welcome additional return. But when the market turns to bear, share prices fall, yields rise and dividends can suddenly make all the difference.
The inverse relationship between price and yield means as the value of shares has fallen, the FTSE All Share yield has risen from around 3% to today's 4.8%. In so doing, the yield makes a much larger real and relative contribution to return. During bear markets, when returns are hard to come by, dividends matter more.
Growth investors will often instinctively look for dynamite hidden in their investment that will provide explosive growth. But those opportunities are often few and far between. Investors should not overlook the long-term power of compounded dividends.
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