The allure of the dividend

Economy | Wed 15 Feb | Author – Business & Finance

A yield approach to equity investing is becoming more and more attractive while dividend growth is playing an important part in generating return, writes Paula Niall.

Given that government yields have plummeted and interest rates are expected to remain at low levels in the medium term, investors are challenged to find opportunities to generate income from their investments. In this reality, a yield approach to equity investing is becoming increasingly attractive. Dividend and dividend growth has been shown to play a critical role in delivering return.

Firstly, according to Société Générale, more than 80% of European equity total return has been attributable to dividend and dividend growth over the past 30 years. Secondly, research also supports the notion that investing in equities with above-average dividend yield and dividend growth, has historically produced a return above market average return. Investors often underestimate the duration of the growth and returns of dividend paying companies, creating a value opportunity for investors.

Equity dividend investing is an attractive option given low yields elsewhere

The US Federal Reserve recently announced its intention of extending its near-zero interest rate policy to 2014, while in the UK, the Bank of England voted to hold interest rates at their record lows. Across emerging economies such as India, Thailand, China, Brazil, Philippines and Indonesia, interest rates are on a downward trend. At the same time, liquidity is being enhanced by another £50bn in quantitative easing in the UK and the provision by the ECB of loans to European banks, all of which add further downward pressure on interest rates. Furthermore, in the Western world, huge fiscal austerity programmes have been put in place to reduce debt. If this debt deleveraging cycle continues and lower growth is the outcome, then interest rates will stay lower for longer. In this environment, investors have few options for yield.

Dividend growth is key to determining the attractiveness of the investment opportunity
Investors are attracted not only to the dividend payments themselves, but also the quality of those dividends and the ability to grow them. Dividend-paying stocks require sustainable cash flow, healthy balance sheets and a disciplined asset allocation strategy. In order to be valuable, a dividend stream must be sustainable. Sustainability of dividend is determined by the availability of cash flow growth opportunities in a company’s marketplace.

A commitment by management to maintain a high dividend payout can assert a discipline on management, ensuring that it is selective about its allocation of resources among the various options. Conversely, low payout ratios can lead to investment in less appealing projects, resulting in poor subsequent growth. It is important to understand how a company spends its cash flow. For example, it can allocate cash to increase its dividend, buy back shares, reduce debt, reinvest in the business or seek acquisitions. A focus solely on a high yield can be misleading, as in isolation it says little about the quality of a company. A high yield can result from financial stress.

An increase in dividend can signal management’s confidence in the business

There is a common perception in the market place that a company only increases its dividend if it has gone ex-growth and has no alternative use for its cash flow. Research by Aharony & Swary (1980) dismissed this idea, demonstrating that companies which increased their dividend, subsequently went on to achieve on average higher earnings growth. Concurrently, companies which cut their dividend subsequently achieved declining  growth.

Dividends are inflation protected

Despite the low economic growth in the Western world, we are still seeing some inflationary pressure. Inflation usually leads to rising nominal earnings (maybe real), and if a company maintains a similar payout policy, its dividend will rise at least in line with inflation. According to a report by BNP Paribas, dividends have tended to grow, on average, by 1.5 percentage points above inflation. There is extensive historical evidence supporting the notion that equity dividend yield provides a healthy hedge against inflation.

Dividend-payers stocks have outperformed over time

Dividends are a vital element of return. On average, over the very long term, dividends have accounted for some 90% of the total return of S&P stocks. The importance of dividend is also evident within shorter time frames. For example, over a five-year time horizon, dividend yield and dividend growth account for almost 80% of the return of S&P stocks. The importance of dividends over the long term isn’t just a US phenomenon. For instance, in Europe 90% of UK, Germany and France returns since 1970 have come from dividends.

Dividend-payers have outperformed non-dividend payers historically

According to Credit Suisse, companies with a high dividend yield have outperformed companies with low-to-medium dividend yield over the 20-year period to June 2011. It is worth noting that when US stocks suffered a “lost decade” during 2000-2009, global dividend-payers achieved a positive cumulative return of 9% over that period.

Valuations are attractive currently, as now is the time to buy dividend paying stocks

The cash levels on companies’ balance sheets are at historical high levels.

Dividend-paying stocks are currently offering not only income, but also potential for capital gain. Due to the fact that the consensus view is that growth and returns fade over time, the markets often underestimate the duration of the growth and returns of high-quality companies, creating a value opportunity for investors.

There is no ‘magic solution’ for investors to achieve long-term outperformance. However, a qualitative approach to dividend investing, which examines a company’s cash flow sustainability, its balance sheet strength and its dividend policy, can help investors to achieve outperformance in this current low-yield environment.