Recent economic and stock market developments are forcing investors to re-evaluate and recalibrate their investment strategies. In today’s world of lower economic growth, low bond yields and paltry interest rates, investors must increasingly look to alternative sources to meet their income needs.
Investing in dividend-paying stocks provides defensive qualities while the yields currently on offer are high by historical standards and compared to other assets. Equity income investing is also supported by historical evidence that suggests dividends not only account for a large share of total returns, but that consistent dividend-payers and growers also tend to be excellent stock market performers over time. All in all, this makes investing for equity income a compelling proposition in today’s market environment.
WHY NOW IS THE TIME TO FOCUS ON EQUITY INCOME
Among the key requirements for successful investing is an ability to respond effectively to changing conditions. Today’s economic backdrop is one of increased uncertainty, where risks abound, where economic growth is lower and likely to stay low and where bond yields have been pushed down to historic lows. In these testing conditions, it becomes more challenging for companies to produce consistent and reliable earnings. Increased uncertainty about the outlook for companies pushes share prices lower and increases volatility. As share prices fall, dividend yields often rise above historical norms. This has happened across a range of global equity markets. Investing when dividend yields are high has historically been a good time to invest as it is often followed by a period of appreciation in equity markets.
Dividends become strategically more important in uncertain times. In tough macro and market conditions, investors begin to adopt a more defensive approach by favouring those companies with stable earnings, who have a proven ability to produce good results regardless of the ups and downs of the economic cycle. Companies whose earnings are reliable and who have a consistent record of paying out and growing dividends therefore become particularly attractive. Investing in such companies not only gives investors the comfort of an attractive income stream in an otherwise low yield environment, the dividend payouts also provide a cushion against possible price declines.
- Dividend yields globally are currently well above their 15-year averages.
- Dividend investing strategies tend to have defensive qualities that are well suited to the current challenging environment.
- Over long time periods, reinvested dividend payments can account for the majority of total returns.
- The evidence suggests that consistent ‘dividend-payers’ and ‘dividend-growers’ are also excellent performers over time.
- The evidence also suggests that dividend-payers outperform across market cycles, in both bear markets and bull markets.
- Proven dividend-payers and growers tend to have healthy balance sheets and cash flows.
- High yields can indicate fundamental weakness in a stock, so careful research is required to find those companies whose dividends are sustainable.
THE IMPORTANCE OF THINKING IN TOTAL RETURNS
While dividend payments are obviously attractive for those who may need a steady income for spending purposes, the reinvestment of dividends plus the passage of time turns equity income investing into a long-term growth strategy. When long-term total returns are analysed for investors who choose to reinvest their dividends, it becomes clear that it is actually the compound growth effect on reinvested dividends that accounts for the majority of total returns.
The key to understanding why reinvested dividends can be so productive lies in the power of compounding. Numerous studies illustrate the benefits of dividend reinvesting combined with compounding. For example, the Barclays Equity Gilt Study in 2011 showed that $100 invested in the US stock market in 1925 would have grown to $9,524 by the end of 2008 without reinvesting dividends - but to $302,850 if dividend income was reinvested throughout the period.
The power of reinvesting dividends grows exponentially over time and the compounding effect of dividend payments kicks in sooner than many investors might think. It takes an average holding period of only 5-6 years for income to overtake capital growth as the primary driver of a stock’s total return. Moreover, the compounding effect is boosted if the divided payments are relatively large by historical standards - as is the case today.
 Sourced from the Brandes Institute based on stock market data from 1926-2003.
PROVEN DIVIDEND-PAYERS ARE ALSO GOOD PERFORMERS
There is a presumption among many investors that high-dividend paying companies tend be lower earnings growth companies, while low or non-dividend-payers have better growth prospects. This is probably rooted in the belief that low dividend-payers are busy ploughing their earnings into a host of high value projects that will grow earnings and provide share price gains that more than make up for the lack of dividend payouts. While this idea may have some intuitive appeal, it is not borne out by the evidence. On the contrary, an academic study by Robert D Arnott and Clifford Asness reached the opposite conclusion - expected future earnings growth is fastest when current dividend payout ratios are high and slowest when payout ratios are low. Moreover, according to the study, this relationship is not subsumed by other factors, such as simple mean reversion.
 Robert D. Arnott and Clifford S. Asness, Financial Analysts Journal January / February 2003.
The fact that many dividend-paying companies also have a proven track record of growing earnings helps to explain why their share price performance is also comparatively better. Importantly, this is true across market cycles. Owing to their defensive qualities, it is perhaps not so surprising that dividend-payers outperform in bear markets, but more surprising may be the evidence (left chart) that suggests that this is also true in bull markets, providing investors with over 3% more every year during the last ten US bull markets.
There are some great examples of companies with outstanding dividend paying records, such as Procter and Gamble; a company which has a 55 year history of sequentially increasing its dividend. P&G shareholders have been well-rewarded over the years and dividends have played a huge role in providing that exceptional total return. The facts are at odds with the view of some investors that P&G is as a relatively uninspiring consumer staples company. It may not be a ‘glamour stock’, but few investors would argue that these total returns are not glamorous.
PROVEN DIVIDEND-PAYERS SHARE GOOD FUNDAMENTAL FEATURES
Companies that have proven track records of paying and growing dividends over long periods, typically share a set of other characteristics that strengthens their appeal to investors. Firstly, the ability to pay consistent dividends is often (though not always) an indicator of good cash flow and strong balance sheets. In today’s environment of challenging borrowing conditions, this is of particular value and a source of real comfort to investors. Secondly, a good number of dividend-paying companies tend to be mature, well-established blue chips that sell products that benefit from instant brand name recognition. To a great extent then, reliable dividends can be seen as a good indicator of quality, well-managed, cash generative companies.
SOURCES OF DEMAND FOR INCOME-PAYING INVESTMENTS
Like all financial assets, stock prices ultimately reflect the interaction of both supply and demand side factors. On the demand side, a growing appreciation of the benefits of equity income investing among investors could increase investor interest in dividend-paying stocks, and should support their share prices. Taking a longer-term point of view, it is also possible that demographic developments will support the case for equity income strategies. The increasing number of older people, especially in more developed countries should support demand for reliable and relatively safe income-paying stocks.
Traditionally, retirees have always been encouraged to achieve their income needs by increasing their allocations to bonds. However, the credit crunch has changed the landscape of the bond market. With some government bonds subject to an unexpectedly high degree of credit risk and many of the safest government bond yields at record lows which make them expensive, it is reasonable that retirees and their advisers will increasingly see the value in high-quality, dividend-paying stocks.
THE SUSTAINABILITY OF DIVIDENDS IS KEY
While equity income investing has many attractions in low-growth conditions, good stock selection is of critical importance. A high yield can indicate that a stock is trading at a discount to its intrinsic value, but good stock selection is critical in identifying the best equity income opportunities in order to avoid ‘value traps’. For instance, the earnings and dividend payments of some multinational companies can occasionally be boosted by currency movements or simply a temporary peak in earnings potential that is unlikely to continue. More importantly, a high yield can also reflect the fact that a company’s earning prospects have deteriorated significantly so that the fall in its share price has increased the yield ratio on offer.
A very high level of research due diligence is therefore required to ascertain which stocks can genuinely sustain and grow their dividends. During the recent financial crisis, earnings dropped sharply, by such a degree that dividend payments were no longer sustainable for many companies. This was very much the case for European and US banks. At first, the share prices of these banks fell sharply - for a while, they signalled very attractive dividend yields, but any investor buying into this false signal would have been sorely disappointed because the dividends of many banks were subsequently scrapped.
The key then is to select those high-yielding companies whose financial condition is strong and who have few risks on the horizon that might compromise their ability to keep paying their dividends. Even more valuable are those companies which not only continue to pay but also continue to grow their dividend payments.
The investing landscape has changed. The unusually high returns from stocks once available in western equity markets during the 1990s seem a distant memory in the post-credit crunch world. In the current environment of lower growth and lower interest rates, the forgotten value of investing in income-generating stocks reasserts itself emphatically. Stocks, globally, are currently yielding well above their 15-year averages. The extra returns from dividends can provide a valuable margin of safety against any price declines if volatility continues. Furthermore, the evidence suggests dividend-paying companies tend to outperform their counterparts who retain earnings. The fact that many of these proven dividend-payers are high-quality, blue chips with strong balance sheets and high cash flows is also attractive.
Moreover, total returns can be hugely enhanced if dividends are re-invested. History shows that over the long run, it is actually the compound growth of reinvested dividends that deliver the majority of total returns. In short, equity income plus patience is a fantastic growth strategy. However, it is one that requires investment to be made in stocks paying sustainable dividends. For that to hold true, the value of high quality fundamental research cannot be underestimated.
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