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Attention returns to income and dividends
Sunday Business Post - May 2nd 2010
by John Mattimoe, Senior Portfolio Manager, Appian Asset Management
If interest rates remain low, dividend growth prospects have much appeal for investors, writes John Mattimoe.
"Do you know the only thing that gives me pleasure? It's to see my dividends coming in" - John D Rockefeller
The launch of the National Solidarity Bond has brought a welcome spotlight back on to investment income, the unsung ally of the long-term investor. During the heady equity bull market phases of the 20 years prior to the financial crisis, equity dividends were not gone, but often overlooked.
Now, as the worl cuts its cloth, and as households and companies cut their borrowings, economic growth rates will be more modest and the prospects for huge or 'super-normal' capital gains from equities will be limited.
That means dividends, particularly the dividend growth prospects of a stock, will receive more attention from investors, especially if interest rates remain low for an extended period or if inflation accelerates.
There are many attractive dividend 'plays' still available. Take, for example, one of the world's best-known food manufacturers, Nestle, makers of Nescafe and Cheerios, amongst a stable full of brands. Nestle is a well-diversified blue chip company that pays a dvidend yield of 3.5 per cent, which is covered almost two times by its earnings.
It has a low level of debt (12 per cent of equity) and has increased its dividend by 14 per cent p.a. on average over the past 10 years. This is quite attractive for someone with a tolerance for some equity risk and who wants more than a fixed income yield (to maturity) of c. 4 per cent, such as with the National Solidarity Bond.
However, investors who opt to lock into a fixed-income yield should remember that inflation is, in our view in Appian, very likely to make a dramatic return as a by-product of the vast amount of money pumped into economies and the global banking system by governments and central bank as a response to the financial crisis.
On average, equity dividends grow over time as the profits of the company grow. This dividend growth potential also provides a hedge against inflation.
Companies tend to be real assets, so in inflationary periods the rate of growth in their profits and cash flow is higher, allowing a faster rate of dividend growth, providing investors some compensation for the erosion in the purchasing power of their money.
Critical to the overall equity return
Judging the performance of a share investment over a period by just looking at the movement in the share price takes no account of the return generated from any dividend paid. Dividends, in fact, are a key component of the long-term return from equities.
The impact of reinvested dividends over time is dramatic, with the power of compounding. For example, the capital value of $1,000 invested in the S&P 500 at the end of March 1990 would be worth $3,440 20 years later. However, by reinvesting dividends received, that $1,000 would have grown to $5,235 at the end of March 2010.
Income return is not dependent on the share price of the stock on any given day. This allows a patient investor with a longer-term perspective to buy an undervalued dividend paying stock, and then collect their dividend each year while waiting for the value of the company to be recognised in the share price. It is also worth noting that companies focused on a consistent dividend policy are often more disciplined in using their capital. A regular payout means less profits are retained for deployment on acquisitions or share buybacks, which in many cases have proven to be value-destroying.
Characteristics of a good dividend 'play'
When seeking a good dividend-supported stock, investors should look for companies with a sustainable business trading on an attractive dividend yield (the dividend per share as a percent of the share price) with modest debt levels and profits that comfortably cover the dividend payout (the greater profits exceed dividends usually indicates that the company can better sustain or increase its dividend over time).
Furthermore, having good opportunities to re-invest profitably in its business is a good indicator that a company can increase profits and its dividend in the future. A dividend yield that is close to or above deposit rates is usually regarded as attractive, as it will usually grow.
Tesco, for example, is a strong company with a sustainable business and good growth prospects. Its current dividend yield is 3.2 per cent, and it is covered more than two times by its profits. Furthermore, it has increased its dividend by 11 per ent p.a. on average over the past decade - every little helps! Gearing at 64 per cent is not at a level that would be regarded as low, but given its robust cash generation, the group financial risk would still be considered low.
Pfizer, the US pharmaceutical giant, has a solid, defendable business model. It also has a 4.4 per cent dividend yield, which is covered three times by earnings and is backed by a balance sheet which has a debt to equity ratio of just 19 per cent. The dividend has grown by 8 per cent p.a. over ten years, no doubt helped by one of Ireland's most successful export stories of the last decade - Viagra.
Risk factors on equity dividends
As clearly seen in recent years, equities are volatile and risky assets. Therefore risk assessment is critical, regardless of whether the equity is being purchased for dividend income or for capital growth prospects.
A dividend payout does not necessarily make a share less risky than a share which pays no dividend, as dividends can be reduced or stopped completely. Investors need to consider the ability of the company to sustain its business and dividend, particularly in relation to the financial risk of the company - the greater its indebtedness the higher the risk to its dividend-paying capacity.
Sector risk is also important, as high-dividend-yielding sectors often have high financial risk. Concentrating on such a sector can leave a portfolio vulnerable to those financial risks.
This risk was clearly highlighted during the recent financial crisis. Many income or high-yield funds were overconcentrated on bank and financial stocks, attracted by the high yields of such stocks, but without fully regarding their financial risk.
Consequently, during the banking ciris these funds lost much of their dividend income inflow as banks cut or suspended their dividends. Adding instult to injury, the capital values of these funds also suffered from the precipitous fall in the share prices of banks.
The lesson is that it is not always about the highest yield, but about having the best balance between yield, risk, sustainability and potential growth.
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