Are dividends the way to go in equities?

Firms that grow their dividends can yield a 'double compounding' effect.

By ANDREW HENDRY

WHILE many investors focus on capital gain as the main source of return from equities, history shows that long- term returns are enhanced a lot by the inclusion of dividends. Just take the outcome of a US$1,000 investment in a portfolio of US equities since the beginning of 1970. The capital alone has increased to US$13,474, but the total return - which includes dividends and the reinvestment of those dividends - has risen to US$51,377. The difference is accounted for by the benefits of compounding - that is to say, the amplifying effect of reinvestment.

However, this compounding effect can be further enhanced if an investor were not to focus just on any dividend-paying stock, but on companies that can grow their dividends, resulting in a "double compounding" effect. For example, had you invested US$1,000 in the US stock market 10 years ago, your stake today would be worth US$1,980, including the reinvestment of dividends. Now if you were fortunate enough to have put this money not in the broad market, but instead into an elite group of companies in the US called the "dividend achievers" - companies which have rewarded shareholders with a rising dividend every year for 25 years or more - your investment, on the same terms as above, would have increased to US$2,750. That is a vastly superior return to simply investing in the index. As a consequence, for this to work to greatest effect, you need to concentrate your money on companies that increase their dividends year in, year out - and stick with them for long periods of time. Consistency and patience are what's required. But what about high-dividend yields, so often targeted by equity income strategies? A high yield is not an automatic signal of value. In fact, it can often be a sign of trouble or limited growth potential. Without growth in the business, a company cannot sustain long-term dividend growth. Consequently, the return profile of a telecom or utility sector - industries which currently yield the most - is typically predictable but unexciting; very much like a bond, in fact. A 6 per cent yield today is likely to be 6 per cent in three or five years' time and the dividend stream will be exposed to the eroding effects of inflation. Investing in companies that can increase their dividends over time is much more compelling because dividends and share price performance go hand in hand. It is better to begin with a lower starting yield compared to the highest yields in the market if you insist upon growth in the dividend stream because rising dividends will lead to higher yields in the future. Yield tomorrow is more interesting than yield today. More importantly, a rising dividend stream will create pressure for the share price to perform. The combination of a higher dividend and a higher share price can be a powerful one for investors.

Take, for example, Nestle - the world's leading food- and-beverage company with household brands such as Kit Kat and Milo. The Swiss company has a long history of profitable growth and it is no coincidence that the dividend track record is equally impressive: Nestle has raised its dividend every year for 16 consecutive years with an average annual growth rate of 13 per cent. Back in 1996 at the beginning of this sequence, the shares were yielding a paltry 2.4 per cent - too low to be considered by many dividend investors. However, the dividend has increased more than six-fold since then. So the yield at the outset, with the benefit of perfect hindsight, was actually more than 15 per cent. Not surprisingly, the strong growth in the dividend stream has led to significant capital appreciation and the share price has quadrupled during that time. Looking at the total return, the investor has been rewarded with a six-fold increase in his investment.