The Power of Dividends

21st June 2013

High dividend paying stocks offer two things to the investor: a source of income that currently exceeds that available from US, UK and core Eurozone government bonds or cash accounts, and, secondly, a valuable good hedge against potential rising inflation.

For the income seeker, dividends can provide an attractive source of regular income payments that have the potential to rise in line with increases in inflation, as the underlying companies tend to raise the price of their goods or services in line or above inflation and therefore should look to move their dividend paying policy in the same way. For the capital growth seeker, it is dividend growth and the reinvestment of dividends that often provides stock market investors with the greatest proportion of their overall long-term return.

Dividends for the income seeker

Investors looking for income have traditionally sought the security of risk-free government bonds or fixed term deposit accounts at their local bank. But with yields on the most favoured government bonds often below inflation and the price being demanded for this income, has lead many income seekers to start looking to the equity market to provide an attractive level of income.

The traditional relationship between equities and government bonds, which existed in all the major markets in previous decades, was for the equity dividend yield to be lower than the government bond yield to compensate for the capital gain offered by holding equities. But this relationship has been inverted – in some cases sharply – in recent years.

Income from government bonds in those markets viewed as the safest, is at ultra low levels because of the currently prolonged period of low growth. However, this environment can be positive for higher yielding equities.

First, dividend paying stocks are supported by strong demand given the lack of attractive alternative income sources. Second, high dividend paying stocks are often found in the defensive sectors most able to withstand negative economic shocks.

Dividends for capital growth

Meanwhile, for investors seeking capital growth, dividend stocks are also appealing. The power of compounding means that reinvesting dividends over a sustained period provides a powerful boost to total returns. Over the past decade, for example, the return on the MSCI World Value Index (a good proxy for high dividend stocks) was 47% without reinvested dividends, but 105% if dividends were reinvested (source: Factset, data to 30th November 2012).

Dividends have also been the main driver of market returns over the long term. In each decade since the 1920s, dividends have contributed positively to investors’ returns, providing stability to portfolios and helping to limit losses when markets are falling (source: Factset, Standard & Poor’s).

Dividend-paying stocks can therefore play a dual role in a portfolio: to provide income, particularly in a world of very low interest rates and core government bond yields, and to provide a valuable source of total return over long investment horizons.