Of late, the headlines on dividends have been primarily focused on the proposed removal of some of the more favourable tax treatments should the Labor Party get elected to power. While franking credits certainly enhance the attraction of dividends received from Australian companies to many investors, we believe there are many other important reasons why the dividend income earnt from an equity portfolio will always remain an important element to consider when constructing an equity portfolio.
In our opinion, there are three key reasons why dividends have always been and will continue to be an important component for investors to consider:
- Dividends are a more reliable source of return from an Australian equity portfolio
- The level of dividends received is not impacted by the level of the sharemarket
- The dividend yield on stocks can act as a ‘safety net’ at times of volatility
In this article we look at each of these points in more detail.
Dividends are a more reliable source of return
Over the long term, returns from an equity portfolio come from 2 sources – the capital appreciation from the shares held in the portfolio as well as the dividends received from the shares held.
It is interesting to note that when one analyses the returns from the Australian sharemarket for the ASX 300 of these two components of returns over the last 20 and 40 years the results are as follows:
Source:Calculated using IRESS data indices
The importance of the dividend component of an Australian equity portfolio to investors is evident as seen from the table above where almost half of the returns from the Australian sharemarket in the last 20 and 40 years have come from dividends.
The level of dividends received are not impacted by the level of the sharemarket
While the level of capital returns from an equity portfolio over any defined period generally depends on the movement in the sharemarket, the level of dividends received by an investor from an equity portfolio is dependent on the performance of the underlying companies’ earnings, not the movement in share prices.
The level of dividends and the dividend payout ratio of any company is set by the Board of the company and is generally a reflection of the overall profitability of a company and is independent on the level of its share price.
This is an important point to remember as it means that in negative periods in the sharemarket, an investor’s level of dividends from a diversified portfolio – if made up of quality companies with the right attributes – should not vary greatly from year to year and is irrelevant of what is happening on the overall sharemarket.
The chart below demonstrates this clearly by comparing the volatility of the level of capital return to the level of dividend from the ASX 300 over the last 20 years.
Chart 1: volatility of returns of capital and income of the ASX 300 over 20 years
Source: S&P ASX300 31/03/1998 – 31/03/2018
This trend is again clearly shown when looking at a breakdown of the level of returns from the ASX 300 in Chart 2 below. One can clearly see that the orange bar- the level of dividends paid from the ASX 300 – has been much less volatile than the level of capital returns (the blue bar) from the ASX 300 over the last 20 years.
Chart 2: Income returns to shareholders from the past 20 years have remained consistent
Source: IML and Morningstar Direct, S&P ASX300 01/01/1998 – 31/12/2017
The key point to remember is that regardless of share price performance, the vast majority of companies in the ASX 300 continue to pay dividends not dependent on the mood of the sharemarket, which to some extent compensates sharemarket investors for a share price often beholden to the whims of the market.
The dividend yield on stocks can act as a ‘safety net’ at times of volatility
The movement in the sharemarket – particularly over shorter time periods of 6 to 12 months - is more often than not dictated by the mood of investors - which in itself is impacted by things such as the predictions as to the future level of economic activity, inflation and interest rates as well as perceptions of geopolitical stability.
Often what are, with hindsight, quite minor events from an economic standpoint, can cause the mood of investors to sour markedly and lead to large declines in the sharemarket. For example, Iraq’s invasion of Kuwait in 1991 led to all sorts of gloomy predictions about an impending global recession by many market analysts and economists.
Times of a perceived crisis can cause many investors to panic, and in such times the prices of most shares can fall heavily initially as many investors/traders often reduce their overall level of sharemarket exposure by rapidly selling many shares indiscriminately and independent of their quality. What I have observed over the many years of investing is that once the panic subsides and some sort of normality is restored, those companies with sustainable earnings that can support a healthy dividend stream are often the shares that can recover the quickest.
The reason for this is fairly obvious – rational long-term investors are always attracted to companies that pay a healthy dividend from a sustainable earnings stream as they understand that the level of returns from dividends is not dependent on future share price performance.
In other words, once shares in quality companies fall to a level where the dividend yield is attractive, this will often attract many long-term investors to buy these shares as they ‘lock in’ often attractive dividend yields, despite a volatile sharemarket.
Conclusion
Dividends provide sharemarket investors with a consistent part of their total return and can also act as a ‘safety net’ in down trending markets.
While we acknowledge that the proposed changes to the tax-effective treatment of dividends in Australia via franking credits is potentially a negative development, dividends will remain an important factor when investing in the sharemarket as they will continue to provide investors with a relatively stable part of returns through the delivery of real cash flow, irrespective of the market cycle.
As a bottom-up value manager, fundamentals are crucial to deciding which companies are included in IML’s portfolios - mainly the quality and transparency of the earnings, cash flow generation, gearing levels or balance sheet strength – which ultimately is what is important in the level of dividends paid by companies.
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Comments
Michael Ryan
Anton, if you accept the widely proven fact that a share price will decline by the value of a dividend on the opening of the ex-dividend day, then all of your points become moot (Dr Don Hamson's team themselves provided me with their research on this). For example, a dividend is only a reliable source of return as it is a return of capital to investors - exactly the same outcome would be achieved by selling shares instead if no dividend was paid. Therefore while it is a consistent payment, it is not a source of return as the dividend paid to the investor is offset by a decline in share price. You must then rely on market movements for that share price to recover. If you accept this then you must agree a dividend does not add to your total return at all (however I do accept that franking credits have not been fully included in share prices and therefore may offer an added return). A dividend is simply an easy way for investors to receive back capital without them having to bother selling shares. One would do far better ignoring dividends altogether and trying to build a portfolio that will deliver a greater total return. Income needs can be met more efficiently by then selectively selling shares.
Garry Marsden
Great insight, as always.
Carlos Cobelas
people bought Telstra for it's great dividend yield too and now have substantial capital losses with the share price falling from over $6 to under $3, lower than where it was 20 years ago at T 1 !! should never buy stocks for dividend yield alone. if the earnings aren't growing, the dividends won't grow either and you risk capital losses which outweigh the dividends.
Gordon McGhie
Peter McGhie 15/5/18 Michael Ryan seems not to have taken into account the recovery of the share price as the next dividend comes closer (all other things being equal). A dividend is normally paid out of profit and is best regarded as the company's "reward" for allowing the company to use the investor's capital. Commercial life is never this simple but it is a good point at which to start understanding capitalism.
Michael Ryan
Gordon McGhie, any subsequent move in share price is due to market factors pushing that share price up or down. You cannot be sure the share price will recover at all. After a dividend is paid it will force the share price down - that simple fact I think has been lost or forgotten by most. If you accept it (as you should given it has consistently been shown to be true), then you must realise that a dividend does not in fact actually contribute to your return at all (given the drop in share price caused by the dividend offsets the return provided by the dividend itself) - a dividend is a zero sum game in terms of performance. If the share price gradually goes back up (which we would hope it would) that will be due to other factors such as a more positive outlook for company earnings, or any number of things, however it can of course go down as well. It is unfortunate that this simple principle is lost on most investors, and it is even more unfortunate to see professional investors and commentators also misunderstanding this principle, leading to them misleading others. See the rise in the number of and the popularity of 'equity income' products for example. I am happy to hear arguments to the contrary as I don't purport to be all-knowing, but my own research has consistently proven this principle to be true. Hence why I think an investment portfolio for anyone, no matter your income needs, should be invested with the total return in mind and income distributions irrelevant.
Anton Tagliaferro
Thank you for all of your comments. I agree that dividends are just one important element of assessing when to buy shares in a company. At IML we look for 4 quality attributes: a strong competitive advantage; a history of consistent, recurring earnings; a capable management team; and the ability to grow earnings and consequently their dividends over time. We also seek to buy these quality companies at a reasonable price.