Back in 2005, I wrote a feature looking at the importance of dividends in investing. At the time, the FTSE had hit the doldrums, and income looked a safe way of generating returns in a market where capital appreciation was becoming particularly hard to come by. And while markets may be anything but static in recent months, dividends nevertheless remain a crucial component of any investment portfolio.
The strategies focused on two key points. The first was the importance of reinvesting dividends, which magnifies returns over long periods of time thanks to what Albert Einstein once allegedly described as "mankind's greatest invention: compound interest". By reinvesting dividend income, investors earn on a bigger pot of capital in each subsequent year. Many companies offer dividend reinvestment programmes (DRiPs) to automate this process – if you're a shareholder in one of these companies, it's worth taking advantage of it rather than going through the cumbersome process of banking dividend cheques and buying more shares.
This isn't a strategy for the impatient – about as far removed from day trading as it's possible to be, this approach starts to yield real benefits over 20-year-plus time frames. Research from the gurus of dividend reinvestment: Elroy Dimson, Paul Marsh and Mike Staunton, suggests a time frame of nearer 100 years, pointing out that £1 invested in 1900 would have returned £16,160 by the end of the 20th century had dividends been reinvested, against just £149 had they not. That's a 5.8 per cent annualised return versus an inflation-linked return of just 1 per cent a year. But it will be your great-grandchildren, not you, that see the full benefits.
In addition, high-yielding shares often outperform growth stocks in terms of capital increases. Investment managers such as Neil Woodford know this, which is why their funds consistently outperform the wider market – his Invesco Perpetual income fund has returned 77.8 per cent over the past five years, soundly beating the average return of 30.2 per cent. This kind of approach is often called value investing – it attempts to identify stocks that have fallen out of favour with investors, and which are therefore likely to be offering a high yield and significant potential for share price recovery.
Value investing is also a good way for more capital-growth-hungry investors to get over their hang-ups about dividends. Despite the huge investment benefits offered by income strategies, many stubbornly persist in focusing on daily share price movements and shunning the safe harbour of dull, dividend-paying shares in favour of more racy shares.
To put my ideas into practice, I put together a selection of dividend-based portfolios, each following a slightly different set of criteria. And while it hasn't been possible to gauge the magical effects of dividend reinvestment over such a short time frame, we were able to ascertain how well each of the portfolios did over three years. The results were interesting, but not entirely unexpected.
The exercise demonstrated that, when considered individually, investing metrics are often meaningless. A high dividend yield is as reflective of a company on the brink of disaster as it is a golden investment opportunity. Dividend cover – as we will see – is no guarantee of a company's future ability to pay dividends.
