Why are dividends so important ? The academic literature suggests that dividends benefit investors over the long term in a number of different ways.
The first and perhaps most obvious 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) will actually delivers better returns in and of itself i.e 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 to earnings – annual earnings growth has historically been 2.5 times more volatile than dividend growth according to SG – while the discipline of making the regular dividend payout encourages a more focussed management, determined to conserve the financial resources of the firm. As Lapthorne at French investment babk SocGen reminds us “the retention of a too high proportion of earnings can encourage unnecessary mergers and acquisition (and often wasteful) investment in the pursuit of higher earnings growth”. As an example of this discipline and focus its worth noting that very few companies ever set their management teams a dividends target as a way of calculating their bonuses – the cynic might note how difficult it is too manipulate the dividends stats compared to earnings.
Dividends by contrast are boring and steady. A study by French bank BNP Paribas looked at both US and European Dividend growth over the very, very long term. It found that US equities have not only risen consistently faster than inflation but have increased by a fairly steady 1.4% per annum in compound annual terms – an extra 1.4% every year, compounded makes a huge difference to returns data.
Sadly most investors don’t tend to focus on the boring old dividend payout – they’re much more enthused by the profits or earnings numbers. But these widely followed numbers based on cash profits are also hugely volatile - back in the middle of 2009 for instance various studies by leading investment banks pointed to a precipitous collapse in global stock market earnings of 14% in just one month ! More and more analysts now reckon that earnings estimates are in fact so random – and so liable to sudden downwards revision – that investors should ignore them. One simple example should suffice – back in 2009 for instance analysts estimates for global developed markets suggested that they might be valued at anything between 8 or 13 times estimates for earnings in 2009 i.e. they could be cheap or they could be expensive depending on how optimistic you are !
The one key measure that many analysts keep falling back on is those dividend payouts.. These twice yearly payments are the nearest thing to a sure thing in equity investing. They are of course to a degree dependent on profits and cashflow but many company managers are aware of their totemic value to investors and are reluctant to cut dividend payouts even if profits fall back. In fact a decent number of large UK companies have spent the last ten to twenty years building up a cast iron reputation for being Progressive Dividend payers –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 shares to trade at a premium as global equity income investors snap up their shares.
There’s one other observation worth making about the link between volatile profits or earnings and steady dividends - most investors commonly assume that there’s a very close relationship between profits and dividends but that relationship is not in reality that strong. A team of analysts at French bank SocGen looked at the volatility of earnings growth for instance and dividend growth – earnings were hugely more volatile, with earnings growth oscillating between -35% and +40%,against dividend growth which has stayed between a range of -7% to +19%. In overall terms the SG team concluded that annual earnings growth has been 2.5 times more volatile than dividend growth. Crucially when they used a measure called beta to look at the sensitivity of dividends to earnings, they discovered relatively low numbers (0.00 indicates no sensitivity while 1 implies absolute sensitivity) of between 0.12 and 0.50 for nearly all major equity sectors with the exception of healthcare, building and construction and travel & leisure. The point here is that dividends don’t change as much as earnings and that that markets value that consistency.
Turning to the academic research on dividends it’s clear that the long term case for dividends and their importance to private investors rests on a huge range of factors – the dividend payout itself, the rating attached to a high yielder and the stable growth in the dividend payout over time - but it’s the reinvestment of these dividend payouts that really makes the huge difference over time. The hard spade work on this analysis comes from the London Business School Professors Elroy Dimson, Paul Marsh and Mike Staunton – featured regularly in their Credit Suisse Global Investment Returns Yearbooks. Like many analysts they break the long term returns from equities down into four components – the actual yield itself (usually compared to the risk free rate of return from holding cash or index linked gilts), the growth rate of real dividends (increased dividends above the inflation rate, the way that the market rewards a company because of its dividend i.e the rating it will give the shares via a measure like the price to dividend ratio and last but no means least the reinvestment of the dividend using schemes like the dividend reinvestment investment plans or DRIPs.
According to 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”. Dimson’s point is that in fact the long term real dividend growth rate is actually only about 1% per annum and thus 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 Dimson et al suggest that the average real capital gain in just stocks plus the dividend payout is about 1.7% per annum (an initial $1000 would have grown six fold), but over the same period dividends reinvested would have produced a total return of 6% per annum (or a total gain of 582 times the original $1000).
Dividend reinvestment REALLY matters and luckily most big progressive dividend payers have their own easy to use dividend reinvestment plans.
Filed Under: Dividends,
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