The TEXPERS Blog

BY NICK CLAY & ANDREW MACKIRDY, Newton Investment Management

The long-term returns from U.S. equity markets eloquently illustrate the role of dividends in wealth creation. While capital gains accounted for the growth of $1 invested in U.S. equities at the beginning of 1900 to $215 at the end of 2011, the additional effect of income and its reinvestment turned that original investment of $1 into $21,978.[1]

Dividends Can Boost Long-Term Earnings Growth

It is often suggested that, by following a dividend-focused strategy, investors are likely to suffer since paying a dividend may be viewed as evidence of the paucity of a company’s investment opportunities. However, various international studies have shown that there is actually a positive correlation between a company’s payout ratio and subsequent long-term earnings growth.[2] They suggest that the payment of a dividend actually encourages greater capital discipline which, in turn, leads to better long-term returns.

Of course, companies may choose to carry out share buy-backs rather than pay dividends.

Proponents of buy-backs argue that, not only are they more tax efficient, they are also equivalent in terms of their effect on the capital structure of a company. While these observations may be theoretically true, it is human nature and incentives that drive human behavior. If done at a price above intrinsic value, share buy-backs are in fact a dilution of shareholder value. Furthermore, a share buy-back is only equivalent to a dividend if it is maintained in a downturn. We observe, however, that companies tend to carry out share buy-backs when times are good and quietly drop them subsequently when conditions deteriorate.[3]

A Focus on Dividends Helps to Lower Volatility

Even during periods in which capital returns fall, dividend income tends to be relatively stable. Once a dividend is established, companies tend to try to keep paying it to avoid the negative signal that the market receives when the payment of a dividend is halted.[4] Crucially, if a dividend continues to be paid after a share has fallen in price, investors receive a greater number of shares upon reinvestment of that income than if the share price had not fallen. Therefore, investors may, by concentrating on the income they receive, withstand the volatility in the economy and in the capital value of their portfolios with greater equanimity.

The Need to Be Active

While the profound role of dividends in long-term real returns is statistically demonstrable, yield alone is not necessarily an indicator of corporate strength. The difference between forecast yields and realized yields, shown in the chart below, demonstrates that in order for an equity income strategy to be successful an active approach to investment is necessary.

Comparing Forecast Yield of FTSE World Income Stocks Versus Actual Yield Achieved, End-1995 to December 31, 2018

Click graph to enlarge.

Source: FTSE World. SG Quantitative Research, Factset, December 31, 2018.

Clearly, companies that are over-distributing to shareholders and underinvesting in their business will be likely to harm their fundamental prospects and jeopardize the sustainability of a dividend. A fundamentally healthy business, receiving enough reinvestment to maintain itself and grow, is a prerequisite for a sustainable and growing dividend stream.

In this context, it is our view that an active approach can improve on the statistical tailwind of dividends in three key respects:

• by ensuring that dividends are backed by sustainable cash-flow streams
• in an uncertain world, establishing that the range of future cash flows and intrinsic valuation is favorably asymmetric
• ensuring that the current share price offers a reasonable degree of margin of safety.

By focusing on these disciplines, we believe an investment approach centered on dividend income – the dominant source of long-term real returns – can boost long-term earnings growth and reduce volatility.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Newton Investment Management nor TEXPERS, and are subject to revision over time.
Article Sources:
[1] Credit Suisse, Global Investment Returns Yearbook (2011) and Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the optimists: 101 Years of Global Investment Returns (Princeton University Press, 2002), with updates from the authors; February 2012.
[2] Arnott and Asness, Surprise! Higher Dividends = Higher Earnings Growth, Financial Analysts Journal, (2003); Gwilym, Seaton, Suddason and Thomas, International Evidence on the Payout Ratio, Earnings, Dividends and Returns, Financial Analysts Journal (2006).
[3] Jagannathan, Stephens and Weisbach, Financial Flexibility – the choice between dividends and stock repurchases, Journal of Financial Economics (2000).
[4] Laarni T. Bulan, To Cut or Not to Cut a Dividend, International Business School, Brandeis University (November 2010).


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