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David Stevenson: dividends may soon be a problem for stock markets

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David Stevenson: dividends may soon be a problem for stock markets

I’ve long taken the view that the biggest upside of most long-term investing is simply capturing a sensible dividend yield and then reinvesting said dividend back in the stock. I’ve written two books for instance, one on smarter stock picking, the other on income investing, and both of them have spent many hundreds of pages talking about the same message: dividends matter. Call it the 'paint drying' model of investing. Think long term, pick up those dividends and then reinvest. That’s it. Boring, isn’t it?

And don’t just take my word for it. French bank Société Générale has a fabulous quantitative analyst called Andrew Lapthorne who works alongside perma bear strategist Albert Edwards. I’ve long followed Andrew’s research and his message is also that dividends matter. A lot!

He even puts out a cracking regular read called the Global Income Investor Slide Pack which offers the best argument for focusing on dividends. I’ve purloined three charts out of said pack in order to highlight the central observations. The first is below and looks at different regions and long-term data on returns, breaking down compound annual returns into various components such as the dividend yield, dividend growth and multiple expansion, where the price to earnings ratio shoots up because of speculation.. You’ll notice that in the UK it's all about dividends! 

Source: SG Cross Asset Reserach/Equity Quant, MSCI, Thomson Financial Datastream

But there’s an important rider to this long-term analysis. What really matters is not only the dividend and its growth but that you reinvest said dividends, the subject of the second chart. If you’d have spent those dividends you’d only got two-thirds of the total return from investing in equities. So dividends matter, but reinvesting said dividends matters even more.

Source: SG Quantitative Research, Thomson Datastream

The last chart from Lapthorne’s weighty report demonstrates another important rider. He looks at the total return from equities as an asset class, but many investors are tempted to focus only on those with the highest dividend yield. In effect, dividends become not a general bonus of investing in equities but a specific focus of stock selection.

In fund management terms this results in money going into what are called equity income funds i.e funds that invest in higher yielding equities. The chart below shows that a focus on high yield stocks can be dangerous – the red line shows the expected market dividend yield, the blue line the actual yield. The simple message is that if it looks too good to be true in yield terms, then it probably is. High dividend yields frequently spell investment doom.

Source: SG Cross Asset Research/Equity Quant, FTSE, I/B/E/S, FactSet

Talk to most equity income fund managers and they’ll agree with this conclusion. They will suggest a much better way of selecting certain types of equities is to focus not just on the dividend yield but also the balance sheet and cashflow.

This targets those businesses with a decent business franchise, controllable debt and real capital discipline. This income and quality strategy seems to produce bumper profits.

Why? One answer can be found in an academic paper published over 15 years ago by US experts Rob Arnott and Cliff Asness. The paper is called Surprise! Higher Dividends = Higher Earnings Growth and it digs into stocks which have produced a sensible, higher than average dividend yield and found that actually these are better-run businesses. Or in the slightly arcane language of the report, 'the historical evidence strongly suggests that expected future earnings growth is fastest when current [dividend] payout ratios are high and slowest when payout ratios are low'.

The authors conclude their evidence is 'consistent with anecdotal tales about managers signalling their earnings expectations through dividends or engaging, at times, in inefficient empire building'.

Focus on growing dividends 

One way of capturing these ideas consistently is to focus on those stocks where the business has consistently increased dividends over the last five to 10 years. This is called a progressive dividend strategy and it won’t come as surprise to know that many of these progressive stocks are the most over-owned stocks in the private investor universe.

And the good news is that this cautious strategy of backing businesses which put dividends first has paid off in recent times. Index firm S&P Dow Jones has a Dividend Aristocrats index in both Europe and the UK which consistently only invests in progressive dividend payers with decent balance sheets.

In 2018 for instance S&P’s index of big European stocks (including those in the UK), called the S&P Europe 350, returned a loss of just under 10% whereas variants of the Aristocrats index lost between 6% and 7% over the same period.

Back in active fund manager land, numbers from the Investment Association back up this message of outperformance. Over the last 10 years (through to end January 2019) global equity income managers produced a 179% return compared to 177% for global equity funds, while UK equity income fund managers produced a 163% net gain over 10 years. No wonder equity income fund managers with a focus on dividends have proved so popular.

So, case proved? Dividends matter so much that we should all focus on progressive dividend payers who reward their shareholders via regular cheques?

Maybe, but I have my growing doubts about the importance of dividend based investing. My nagging suspicion was crystallised a while ago when I listened to a cracking podcast by Fredrik Erixon, a policy and business pundit who is also the co author of a great book called The Innovation Illusion.

Dividends can put the brakes on growth

In a wide-ranging discussion about why Western growth rates have declined, he pinpointed big corporates as a major offender. They were becoming overwhelmed by a managerial culture where the top leaders were incentivised to only increase their bonuses rather than take risk. This encouraged rent seeking behaviour i.e making businesses boring.

It also helps that most chief executive compensation packages are usually tied in some way to total shareholder returns numbers which include a large dollop of dividends as a form of return. You can’t control the stock market but you can control the dividend payout. Growth rates might be declining in part because corporate managers are choosing to prioritise investors and shareholders via dividends and not investing in capital expenditure.

We can find an echo of this argument in the US currently, where left wing politicians and supporting academic economists are lining up to attack share buyback programmes which have reached truly enormous proportions.

The most articulate exponent of this view has been William Lazonick, a professor at the University of Massachusetts who has studied the impact of stock buybacks. You can read more on his research here. Between 2007 and 2016, Lazonick says that companies in the S&P 500 spent 54% of their profits on stock buybacks. 'Stock buybacks have been a prime mode of both concentrating income among the richest households and eroding middle-class employment opportunities,' he reckons.

Buybacks are in effect a mirror image of dividends, powered by the US tax regime. Many US companies do pay a dividend but its arguably much more tax efficient for investors, many of them institutional, if the corporates don’t pay a cash dividend but squeeze down the equity base via buybacks.

Investing in buyback orientated businesses can be a lucrative exercise in some years but be aware of a major challenge – many US corporates are engaging in massive buyback programmes partly funded by huge increases in corporate leverage. In other words they are borrowing (cheaply) to shrink their equity base.

Back in the UK, one can also begin to detect rather more parochial concerns. I’ve run into many equity fund managers who find themselves almost forced into paying a regular income because if they don’t, they won’t get onto investors' radars.

Take a couple of examples from the world of investment trusts: hedge fund Pershing Square (PSH) recently started paying out a 2.5% dividend so that it could sell itself more effectively to fund buyers looking for a regular income. Another hedge fund called Third Point (TPOU) also started a dividend to become more mainstream.

It's easy to understand why dividends are so popular, especially if you can progressively increase those payouts every year without fail. In the table below I’ve listed the current top holdings of the S&P Dow Jones UK Dividend Aristocrats index.

Aristocrats' crown slips

These are fairly large cap stocks which have grown their dividends or kept them stable for at seven consecutive years. In the list you’ll see many favourites of the equity income fund manager universe: utility giant SSE (SSE), BT (BT), GlaxoSmithKline (GSK), Marks and Spencer (MKS) and Legal & General (LGEN). But I’ve also included in this table some key financial metrics for these well-known dividend aristocrats, and added in BP (BP) and Shell (RDSb), which don't feature in the index, for comparison.

Stock Forecast yield Forecast turnover growth Forecast earnings growth (3 year average) Gearing Dividend Cover Return on capital employed
Greene King 5.10% 1.40% 6.6% (11%) 107% 1.9 7.10%
SSE 8.10% -2.90% -9.9% (5%) 165% 0.7 7.50%
Legal & General 5.90% n/a 6.8% Pre tax profits (17%) n/a 1.8 21.5% (RoE)
BT 7% -1.40% -2.8% (1.7%0 139% 1.7 11.40%
Imperial Brands 7.30% -1.40% -2.8% (1.7%) 139% 1.4 11.40%
GlaxoSmithKline 5.30% 3.30% 30.10% 598% 1.5 17.40%
Marks and Spencer 6.90% -3% -11% (-4.1%) 60.80% 1.4 10.90%
Energy stocks            
Shell 5.80% -9.40% -12.40% 38.70% 1.4 11.70%
BP 5.50% -8.40% -9.80% 66% 1.3 10.40%

At this point most equity income managers will say that they’re much more careful in picking stocks than this automated index from S&P Dow Jones.

They’ll echo the argument put by Lapthorne that you need to positively screen for, say, debt and gearing or earnings growth. But the reality is that many of the names in this list are still popping up in many equity income fund portfolios. As are the integrated energy majors Shell and BP where dividend yields are both above 5.5% and likely to grow as long as oil prices don’t collapse.

But the energy businesses perfectly demonstrate my growing concerns. Shouldn't they be using all that bountiful corporate cashflow to reinvest in new renewable technologies and diversify their business models away from a reliance on hydrocarbons?

Both will say that they are serious about renewables but I’m not convinced. Both are choosing to prioritise their dividends rather than a massive step change in renewables investment. That might make sense for existing investors but it could be a disastrous decision for wider stakeholders, not least future shareholders.

Dividends matter, yes, but not to the exclusion of other corporate objectives. Fund managers beware: dividends might soon become the problem, not the solution, for volatile equity markets.

Any opinions expressed by Citywire or its staff do not constitute a personal recommendation to you to buy, sell, underwrite or subscribe for any particular investment and should not be relied upon when making (or refraining from making) any investment decisions. In particular, the information and opinions provided by Citywire do not take into account your personal circumstances, objectives and attitude towards risk.

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