Why a Blind Focus on Dividends can Destroy Wealth...

At the risk of sounding a bit like a broken record, dividends matter. It’s boring and a bit predictable but dividends do provide one of the few certainties in the ever-so risky world of investing – that regular, bankable dividend cheque can be a lifesaver. 

If you do need any reminding of this ‘wisdom’, take a peek at the chart below which is from index research firm S&P.It looks at dividends’ contribution to 10 year annualised returns for a number of very broad market indices (BMI). At one end we can see that dividends contributed just 21.6% of the total returns for S&P’s emerging markets indices whereas in Europe that number rose to a whopping 60%. The best ‘big picture’ number is for the S&P Global BMI index which pretty much covers ALL major investable equity markets globally – dividends provided 44.5% of total returns.

In sum this data from S&P suggests that dividends matter a great deal.

Chart – contribution of dividends to total 10 year annualised returns for major S&P indices

The S&P data also goes on to look at their own suite of indices where the companies in an index are skewed towards those that regularly increase dividends. Our favourite S&P dividend focused index is the Aristocrat based Dividend Opportunities range which track companies that have regularly increased payouts for the last 5 to 10 years – according to S&P, the global opps index has regularly outperformed the equivalent non-dividend focused index (the Global Ex-U.S. BMI) “in eight of the 10 calendar years ...and on an annualized basis over the last one, three, five and 10 years. On an annualized basis over the 10 years ended December 30, 2011, the S&P International Dividend Opportunities Index total returns were 12.73% while the S&P Global Ex-U.S. BMI total returns were 7.43%.”

The bottom line ? Dividends matter and there is some strong evidence to suggest that weighting both your index and your fund trackers towards companies that prioritise dividends is a fruitful strategy.

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But there’s a catch...

And it’s a very important catch – a blind focus on dividends without looking at any other fundamental measures can also potentially destroy your hard-earned wealth. 

Many investors’ take the simple idea of buying high yielding stocks and then apply it on an individual stock by stock basis, buying reliable ‘blue chip’ stocks. On paper it sounds like a great idea – look at a big liquid market like the FTSE 350 and then set up a ‘filter’ or ‘screen’ which will slim down the universe of stocks (350 big companies in this case) and throw up a short list of ‘quality’ divi stocks. In the box below I’ve outlined one such dividend screen for individual shares – we’ve looked for market cap above £100m, dividend cover of 1.5 (that means that for every £1 of dividend paid out, there’s £1.50 of earnings) plus a current or historic yield of 5% or more.

Screen Measures :

• Market Capitalisation is above £100m
• Dividend Cover is above 1.5
• Historic Yield is above 5% per annum

This screen is very simple and very cautious – it also doesn’t turn up that many companies. In the next table I’ve listed the stocks that pass this test in the UK market. In all 17 companies feature and again, on initial inspection, they look interesting as a collective group. There are a few giant companies such as Vodafone and AstraZeneca along with a large number of respectable mid cap companies such as Kier and Interserve. The average yield is 6.57% and only three companies on the list boast a price to earnings ratio in the double figures – most look very reasonably priced. Crucially dividends are nearly always well covered and interest cover is generous. 

The Good News

Unfortunately the next table tells us a very different story. One should always take the view of an analyst with a massive pinch of salt, but even I’m worried that the consensus view is that these stocks are weak buys at best, with most a hold and one (Home Retail, owner of Argos) a weak sell. Operating margin’s are an average of 9.44% but many boast margins in the low single figures. The last column looks at forecast earnings per share growth in the coming financial year – only five show any growth at all whereas many show substantial forecast earnings declines. The average EPS decline across the growth is 10.89%, which is mirrored in the cashflow per share growth (forecast, again) column – the average ‘estimated’ decline is -13% per share.

The Bad News

We don’t have any especially strong views either way about the stocks in this list, although we think that BAe and Vodafone are good quality names with a more than decent business whereas AstraZeneca and Drax look a little more volatile but potentially more promising in the long term. But our point is that if we were offered up this basket of shares, we’d pass. And the key point is that a number of dividend focused screens throw up similarly unappealing mixes at the moment. Individual stocks can seem attractive but broader indices look far less appetising.

Our conclusion?

Dividends do matter but so does the mix of stocks within the index or portfolio. Balance sheets are important as is the ‘attitude’ of the company to dividend payouts i.e do they commit to growing that dividend payout? Is there enough cash to afford those dividends and is the core business actually growing in this difficult international economy? All of these questions and more need to be asked by the investors when they look at their dividend portfolio or index tracker – look at the companies and make sure you are happy with the mix. If dividend investing was simply about picking the highest yielding, biggest names, everyone would do it and it would be the biggest free lunch in history, It isn’t and dividend investing is hard work, requiring lots of due diligence and proper analysis. Be warned.