Dividends are back in fashion. You would have to go back to the racy years of the 1980s and 1990s to find investors who thought dividends, like Gordon Gekko's lunches, were for wimps and that owning shares was purely about chasing rising prices.
However, getting decent dividends is only part of the battle. Making sure you pick stocks that can keep paying them – and increasing them – is the trickier part. Anyone can race through a stock screener, cherry-picking the stocks with the highest dividend yield. But that way lies disappointment. The sustainability of dividends is far more important and requires some checks – many completely obvious but some quite subtle – into whether or not that fat dividend payment is likely to keep coming your way.
Why dividends matter
The bulk of long-term returns from investing in shares has always come from reinvested dividends, as the Barclays Equity Gilt study makes clear. If you had invested £100 in shares in 1945 and spent the dividends, your portfolio would in real terms have been worth £241 by the end of 2009. But if the dividends had been reinvested, it would be worth £4,011 – 16 times the performance from prices alone. That is certainly something to think about the next time you look at an apparently exciting company that has no plans to make a payout.
Dividend growth may not seem as important as raw yield, but in the long term it can provide more income. The table below shows how a company that has a relatively low, but fast-growing dividend can outstrip a company with a high initial dividend that only grows slowly.
| Year | Grower | Yielder |
|---|---|---|
| 1 | 3.0 | 6.0 |
| 2 | 3.9 | 6.3 |
| 3 | 5.1 | 6.6 |
| 4 | 6.6 | 6.9 |
| 5 | 8.6 | 7.3 |
| 6 | 11.1 | 7.7 |
| 7 | 14.5 | 8.0 |
| 8 | 18.8 | 8.4 |
| 9 | 24.5 | 8.9 |
| 10 | 31.8 | 9.3 |
| TOTAL | 127.9 | 75.5 |
The 'grower' increases dividends at 30 per cent a year, the 'yielder' starts high but grows at 5 per cent. Clearly with earnings that support this level of dividend growth, the share price rises may be quite spectacular, too. More subtly, dividends can predict subsequent share price movements, thus leading the way to both capital gains and a good income. Companies whose dividend yield is above their own historic average tend to outperform subsequently, while those whose yield is lower than average underperform.
