The role of dividends

In the case of the Bearbull fund, the amount distributed in the first half was £5,342. That was just 2 per cent more than for 2020’s first half when dividends were being savaged. Yet, last year’s mayhem chiefly started in the second quarter by which time the fund had quite a lot of income under its belt, especially the best part of £1,000 from bowling-alley operator Hollywood Bowl (BOWL), whose bosses would not have been so generous had they any inkling their business was about to be shut down by government diktat. So a 2 per cent rise is okay, especially as the fund now has more holdings in lower – and hopefully safer – yielding equities than a year ago. Besides, it still generated a 4.1 per cent annualised yield, the best part of 1.5 times that of the FTSE All-Share index; this despite the fact its value rose 15 per cent in the first half, compared with 9 per cent for the All-Share.

By and large, I am a fan of equity investing for income and of companies paying out much of their net profit in dividends. However, the debate about dividends – to pay them or not to pay – is nuanced. There is not necessarily a right or a wrong. To explain, let’s start with the chart.

First, a word of explanation – the Bearbull income fund has always paid out in distributions all the income it receives, which is mostly dividends but also a little interest. Thus the terms ‘dividends’ and ‘distributions’ are pretty well inter-changeable. The fund was launched with £100,000 of capital way back in late 1998. Since then it has added almost £177,000 of capital gains (both realised and book profits), hence the fund’s current value of £277,000. The capital gains are shown as the blue shaded area at the bottom of the chart and are notable as much for their volatility as their upwards path. From mid-2007 to mid-2009 and again from mid-2019 to mid-2020 the fund sustained painful losses. The upshot is that capital gains, which peaked at approaching £216,000 at the end of 2017, are now about 80 per cent of that level.

Meanwhile, dividends – the orange shading on the chart – have been the tortoise to the capital value’s hare. Their cumulative amount has only ever trundled upwards, even in those few periods when the amount received fell year on year. Back in December 2002, as equity markets were about to recover from their post dot-com funk, the income fund had paid out almost the same amount of dividends as it had accumulated in capital gains – either side of £19,500. Fast forward to the end of 2007, and the eve of the US sub-prime mortgage melt down, bull markets meant that the fund had added £155,000 of capital value to cumulative dividends of just £57,000. When capital value added peaked at £216,000 in December 2017 dividends distributed were catching up at £176,000 and the following December they passed capital gains – £191,000 distributed to £165,000 of gains. After the Covid-19 collapse, capital gains shrunk to £126,000 at their low point, while dividends rose to £213,000. At the latest count, the £177,000 of added value compares with £224,000 of dividends distributed. So, much like the tortoise, dividends had demonstrated their worth by being steady and reliable.

An important underlying point here – and one much in favour of companies distributing dividends – is that a dividend once paid can never be taken back whereas a capital gain is not nearly so durable. At its most punishing, the market had ‘taken back’ £90,000, or 42 per cent, of the income fund’s peak gains.

This is an argument for companies paying dividends whenever they can and for shareholders grabbing them and being thankful. There are, however, contrary arguments. For a company producing a fat return on the capital it employs, it makes sense for shareholders that net profits are retained in the business for re-investment since that should add value to their holdings and – incidentally – it is the reason why the great Warren Buffett never recommends dividends to be paid by his Berkshire Hathaway (US:BRK.B) conglomerate.

Besides, runs the corollary to this point, shareholders should not moan about the lack of dividends from such companies because they can easily manufacture their own by selling a few shares. Quite possibly, that’s more tax-efficient than receiving dividends anyway since – somewhat unfairly – taxation on capital gains is less onerous than on income.

True enough, yet there is a contrary point to consider – the trouble with shareholders creating their own dividends is that they are likely to be too generous to themselves. They will tear off too many metaphorical dividend vouchers and end up frittering away their capital. In those circumstances, it is better to let company bosses be the agents of restraint and reason and recommend distributing only what’s sensible.

Well, yes, except it may be an oxymoron to describe company bosses as restrained and reasonable. As has been well documented, they are perfectly capable of pursuing policies that favour themselves over their shareholders, whether that means distributing too much or too little cash.

And so, back and forth, the argument goes. In practical terms, however, for each and every investor the important question is this: do you need to take income from your fund now or later? Rightly or wrongly, the Bearbull fund has always distributed all of its income, so its challenge has been to build the income flow in real terms whilst also at least maintaining the real value of its capital. The results have been pretty satisfactory, but clearly many readers’ portfolios would focus on capital appreciation – and thereby dividend re-investment – until the day comes when they need to be turned into cash cows. Had the Bearbull fund been run along those lines then it would probably be worth almost another £60,000. Instead of turning £100,000 into £500,000 (capital value and income distributed combined) its value would be about £556,000 had all its income been re-invested at portfolio rates of return. But, of course, all of that capital would still be at risk in bi-polar capital markets. That’s how it is – you pay your money and you take your choice.