Dividends matter. Virtually every long-term study of total returns indicates that dividends account for almost two-thirds of gains. But markets are predicting a new Ice Age in terms of dividends, with payouts abandoned, and the aggregate yields collapsing. One of the keys to surviving this increasingly dismal market is to focus on relatively safe dividends from large companies that have a proven track record of increasing their payout. By focusing on these progressive dividend companies, you might just survive the market carnage.
How do you really value a key market such as the FTSE 100? What constitutes cheap in equity terms? These questions are vexing investors at present. The classic way of measuring the relative value of equities – and their key stock markets – is to look at earnings. But earnings estimates by analysts are crashing – one recent study by a leading investment bank estimated that, last month alone, analysts cut global earnings per share (EPS) estimates by 14 per cent, a virtually unprecedented cut even in a recession. More and more analysts now believe that earnings estimates are so random – and so liable to sudden downwards revision – that investors should ignore them. Based on 2009 estimates, the global developed markets might be valued at anything between eight and 13 times estimates for earnings in 2009 – ie, they could be either cheap or expensive depending on how optimistic or pessimistic you are.
Markets have been trading at fairly cheap levels in most other key measures of value including the ratio between the share price and the total assets of a company (called the price-to-took value). But most analysts believe that measure is also increasingly worthless, partly because bitter experience in Japan tells us that whole markets can trade at much less than book value for years on end and many analysts don't trust the balance sheet estimates of asset values. The big worry is that in a recession any sale of assets will be at fire-sale prices.
Paying dividends
The one key measure that analysts are falling back on is dividends. These twice yearly payments are the closest you'll get to a sure thing in equity investing. They are, of course, to a degree dependent on earnings and cash flow but many company managers are aware of their totemic value to investors and are reluctant to cut dividend payouts even if profits fall back. A decent number of large UK companies have spent the last 10 to 20 years building up a cast-iron reputation for being progressive dividend payers – ie, always maintaining their dividend payout and increasing it every year without fail. In a world of horrific volatility, that reputation has a very real value, sometimes allowing the company's shares to trade at a premium as global equity income investors snap them up.
But the once numerous ranks of the great army of blue-chip progressive dividend payers have been falling away over the last few brutal weeks.
This huge uncertainty means that the ever smaller number of perceived 'safe' dividend payers will be the subject of even more intense scrutiny and interest. There will be more questions asked about the ability of them to afford their payout but, if the market perceives that the payout is safe, it's also likely to attract the interest of the huge number of global equity income funds trying to build a portfolio of solid dividend payers. Already key players such as Newton Fund Management have warned that a flight into these 'safe' dividend payers might sharply bid up share prices for the lucky few.
That army of equity income funds headed by managers such as Neil Woodford at Invesco Perpetual and James Henderson at Lowlands investment trust are basing their preference for well-backed dividend payers on a mountain of solid academic evidence – dividends make a huge difference to long-term returns. In fact much long-term analysis suggests that upwards of 90 per cent of total returns come from dividends in one shape or another.
The academic evidence
The academic literature – backed up by a mountain of analysis from City strategists such as Andrew Lapthorne at SocGen – suggests that dividends benefit investors over the long term in a number of ways.
The first and perhaps most obvious way is the actual regular dividend payment as a contributor to what are called 'shareholder returns'. But the magic of dividends doesn't stop there. There is some evidence that a strategy of buying the right kind of dividend payers (progressive dividend payers with a decent balance sheet) actually delivers better returns in and of itself – ie, the market itself tends to prioritise the attractions of certain dividend payers and awards their shares a premium rating. The reason for this market preference is obvious in retrospect – dividends are easy to calculate and involve simple, hard numbers made in regular payments. But dividends also tend to be much more stable over time compared with earnings – annual earnings growth has historically been 2.5 times more volatile than dividend growth according to SocGen – while the discipline of making the regular dividend payout encourages a more focused management, determined to conserve the financial resources of the firm. As Mr Lapthorne at SocGen reminds us: "The retention of a too high proportion of earnings can encourage unnecessary merger and acquisition (and often wasteful) investment in the pursuit of higher earnings growth".
The long-term case for dividends and their importance to private investors rests on all these factors – the dividend payout itself, the rating attached to a high yielder and growth in the dividend payout over time – but it's the reinvestment of these dividend payouts that really makes the big difference. The hard spade work on this analysis comes from London Business School professors Elroy Dimson, Paul Marsh and Mike Staunton – featured regularly in their Credit Suisse Global Investment Returns Yearbooks.
According to messrs Dimson et al: "The dividend yield has been the dominant factor historically" and they add that "the longer the investment horizon, the more important is dividend income". Mr Dimson's point is that the long-term real dividend growth rate is actually only about 1 per cent a year and therefore can't make that big a difference while the rerating of stocks based on its multiple to dividends is also very variable over time and doesn't make that much of a difference – as the authors note "dividends and probably earnings have barely outpaced inflation".
But the actual payout is dwarfed by the importance of reinvesting dividends. Looking at the 109 years since 1900, Mr Dimson et al suggest that the average real capital gain in just stocks plus the dividend payout is about 1.7 per cent a year (an initial $1,000 would have grown six-fold). But over the same period dividends reinvested would have produced a total return of 6 per cent a year (or a total gain of 582 times the original $1,000). Dividend reinvestment really matters and, luckily, most big progressive dividend payers have their own easy-to-use dividend reinvestment plans .
How to capture dividend performance
The work of the London Business School academics and the SocGen quant team is just one of dozens of studies that suggest that: 1) dividends matter; 2) reinvesting those dividends matters even more and 3) dividends are more stable and less volatile than earnings and the market understands this.
All this wisdom, though, won't matter one iota if private investors can't capture what the industry calls the 'alpha' – extra value creation – of this strategy over time – ie, it may look good on paper but you still have to work out how to build a portfolio that captures this return.
Most academic theorists suggest doing as little as possible and simply 'buying the market' – investing in say a FTSE 100 tracker will probably capture most of that dividend premium discussed in the Credit Suisse/London Business School analysis. But others maintain that a better strategy is to focus in on particular stocks. This rival analysis suggests that weighting your portfolio towards those stocks that pay more dividends will deliver greater returns. Many financial planners have followed this advice over the past decade and invested in a number of strategies – some have put their clients money into simple dividend weighted indices such as the FTSE UK Dividend Plus, which is tracked by an iShares ETF although there's also a newer kid on the block called the Munro Fund that weights the FTSE 100 towards high dividend stocks. The problem is that until very recently this kind of approach hasn't been a great success with very poor returns on show at the iShares Dividend Plus ETF.
Many advisers plump for a more sophisticated approach, which is to trust in funds from providers such as Dimensional and Powershares that track indices which weight the 'market' towards high-yielding stocks with decent balance sheets. Analysis by Eugene Fama suggests that investors can expect a premium of more than 1 per cent if they reorientate their strategies towards value and high-yielding large caps. A plain vanilla version of this approach is to use equity income funds managed by the likes of Neil Woodford and James Henderson, who ignore the index-tracking approach and opt instead for an active approach to stock-picking.
Standard & Poors in the US has tried out a different approach that focuses on dividend consistency. It recently launched the S&P High Yield Dividend Aristocrats index, which according to the developers is "designed to measure the performance of the 50 highest dividend yielding S&P Composite 1500 constituents which have followed a managed dividends policy of consistently increasing dividends every year for at least 25 years” – ie, only those large companies paying an above-average yield, consistently over time.
To be included in the index a company must pass the threshold, which includes:
■ The index is weighted by indicated annual dividend yield;
■ The stock must also have a minimum market capitalisation of $500m (£350m);
■ The company must have increased dividends every year for at least 25 years.
Standard & Poor's has recently launched a European version of the index – see the panel on this page for the British constituents (although this is likely to change in the light of recent developments).
Yet another spin on this strategy of focusing your portfolio on high yielders has recently been proposed by Andrew Lapthorne and his team at SocGen, who have looked at what's worked in developed markets in the past few decades and proposed – in a paper called The Global Income Investor February 2009 – a strategy that requires investors to focus on slightly above-average dividend yielders (110 per cent of the average) as well as those companies with a strong balance sheet (cut out any stocks with above-average gearing).
