Weekly outlook

Six reasons why dividends matter

By Tom Stevenson, 20 May 2009

As if savers were not suffering enough from rock-bottom interest rates, those seeking income in the stock market are now enduring death by a thousand cuts.

Last week BT cut its dividend. This week M&S did the same. At least their shareholders are getting something – ITV and Lloyds Banking Group among others have pulled their dividends completely. Dividends matter more than some investors think. Growth-focused investors sometimes treat dividends as the icing on the cake, but they are more important than this. Here are six reasons why investors should care about dividends: Re-investing dividends has a significant impact on the total returns from stock market investments. Thanks to the magical power of compound interest, dividends can make all the difference to even lack-lustre capital returns. Barclays Capital’s 2009 Equity Gilt study showed that $100 invested in the US market in 1925 would have grown to $6,443 by the end of 2008 without re-investing dividends but to $193,687 if dividend income was re-invested throughout the period.

"Dividends matter more than some investors think. Growth-focused investors sometimes treat dividends as the icing on the cake, but they are more important than this." Tom Stevenson

• At a time of historically low interest rates, high-yield shares can make up for the poor returns on deposit accounts. A year or so ago it was easy to match the 5% yield offered by the MSCI Europe index in a risk-free savings account. Now the income from dividends looks comparatively attractive and the risk to capital of the equity investment is a more acceptable price to pay for the higher yield.
• Focusing on high-yield stocks can improve your capital returns as well. At the market’s lowest point in March 2003, the average share in the MSCI UK index yielded 4.8% while the 10 highest-yielding shares averaged 11.9%. As the market recovered from its low, investors benefited not just from the higher initial income but also from the fact that the high-yielders gained 91% over the next year compared to the 49% achieved by the average share. Buying high-yielding shares can offer a “double whammy” – high income and a high capital gain as well.
• In bull market in which the value of a share is rising at 15 or 20% a year, the addition of 2 or 3% in dividend income is nice to have but no more than a welcome addition to an investor’s return. In a bear market, however, a high dividend yield can offset capital losses and act as a support to shares because the prospect of high and reliable income will bring in marginal buyers. As share prices fall, yields rise, making shares with a decent payout seem attractive compared to other income investments such as bonds.
• Companies are generally unwilling to cut their dividend unless they really have to, although recent cuts have shown that there is less stigma attached to passing the payout than used to be the case. It reflects badly on a company’s management and cuts tend to be punished in the market. For this reason dividends have tended to be less volatile than both earnings per share and share prices. Dividends smooth some of the ups and downs of investing in the stock market.
• Steadily-growing dividends are an indication of the health of a company so it is not too surprising that companies that can boast a rising dividend payout have also tended to outperform the rest of the market, as the chart below clearly shows. Rising dividends are a sign of strong cash-flow, which is the lifeblood of any company. Because of this dividends are not just for income investors.

Dividends have never been more important to savers and investors but there has also never been less certainty about which companies can be relied upon to maintain or, preferably, increase their payouts to shareholders. Research by Fidelity suggests that only a minority of companies can be expected to hold or raise their dividends in each of the next three years. That means investors can no longer simply invest in high-yielding stocks and assume that all will be well. Rigorous research into a company’s ability to keep paying its dividend is paramount.