Dividends can be sexy
When talking about shares, the aspect that tends to get the most attention is price growth. Discussions around the braai are about how Amazon has gone from $100 a share in 2009 to $1 900 a share today, or how the Naspers share price more than doubled between the start of 2015 and the end of last year.
Very few people get excited about dividends. It’s rare to hear anyone express their amazement at how Johnson & Johnson has increased its dividend for 55 years in a row.
In general, investors underestimate just how significant dividends can be. As Paul Stewart, head of fund management at Bridge Fund Managers, points out, over long periods of time earning and reinvesting dividends produces a growing portion of a portfolio’s total return.
“For example, if you deconstruct the performance of the Old Mutual Investors Fund, which has the longest track record of any equity fund in the South African market, 60% of its long term total return comes from dividends and growth of dividends over time,” he says. “The longer you invest for, the more important the dividend element becomes.
“In the short run, over the first five years of an investment, the capital return will far outweigh the dividend,” he says. “But over very long periods of time, 30 years or more, the dividend you receive plus the growth in that dividend is what drives the total return.”
This is one of the reasons why dividend investing is such a popular strategy. Companies that pay sustainable and growing dividends generate growth that is compounded over time.
Dividends are also a good measure of the health of a company. While a lot of stock analysis focuses on earnings, these are sometimes unreliable numbers.
“Earnings and other financial metrics can be fudged, and we have good recent examples of that,” Stewart points out. “The dividend, by and large, is not a fudgeable number because you physically get paid that money as a shareholder.”
With a few caveats, such as that you don’t want dividends paid out of borrowings, one can assume that companies that are able to pay dividends and do so consistently are running high quality operations.
“If you look for companies that grow their dividends sustainably, you tend to get companies that are cash flush, well run, have strong balance sheets, and are able to go through more difficult times and continue to operate,” says Lourens Coetzee, an investment professional at Marriott. “That adds to the quality in your portfolio and the certainty of outcome.”
The downside risk in these companies also tends to be lower than the general market.
“If a company is on a 4% dividend yield and the market believes it will grow its dividend by 8% or 9% per annum over the next few years, it’s very rare that you would see that dividend yield going to 8% because the share price would have to halve,” Stewart says. “This is because these are generally stable, quite large, cash generative businesses.
“However the share prices of companies that pay low dividends or no dividends can have enormous accidents if they miss their earnings or a merger and acquisition deal doesn’t pan out,” he adds. “In those circumstances these companies can have a huge downside risk element.”
The value of dividend investing in the current environment
The resilience of these kinds of companies has been proven over the last decade. The Marriott Dividend Growth Fund, which targets a reliable and growing dividend yield ahead of capital growth, has been the top-performing local equity fund over the last 10 years. It has also shown the lowest maximum draw-down of any fund in this category over this period.
The Bridge Equity Income Growth Fund has been a top 10 performer over the last five years.
Read: SA’s top-performing equity funds
“Half the reason is that these are businesses that sell basic services or necessities,” Coetzee explains. “They are hospital groups, pharmaceutical companies and retailers like Shoprite and Spar that generally continue to sell regardless of what is going on in the market. These types of companies will have some pricing power because what they are selling are things people need, and will continue to buy. The companies don’t have to push the price too much lower to make sales.”
A good international example is Colgate Palmolive, which produces household, health care and personal care products. Around three billion people around the world use its products, and they tend to be loyal.
“In the world we are in now, with Trump and with uncertainty around how things will play out in South Africa, these kinds of themes make a lot of sense,” Coetzee says. “We don’t want to try to pick which companies will do well this year or next year. We look for businesses that have the ability to sustainably grow their earnings over time.”