The Importance of Income

As we wave goodbye to 2011 – a year that seems to have had more than its fair share of political, natural and financial upheavals – attention turns to the future. Will equities have a better year and can gilts reproduce the gains they enjoyed in 2011? To view returns purely in terms of capital gains, however, is to overlook one of the most potent elements of investment - income. 

There are a few key investment rules that stand the test of time: taking a long-term view, good investment diversification and the pursuit of growing dividends. So let’s take a look at dividends.
 
History shows that the best long-term stockmarket rewards generally go to those who are willing to put their money into companies with the ability to generate rising dividends. Firstly, let’s take a global view.
 
During the past 10 years – a period often described as a lost decade for equity investors, because many stockmarket indices today remain at similar levels to 2001 – the total cumulative return from the S&P 500 Index, including the reinvestment of dividends, was just 32%*. However, investors who put their money solely into US companies that increased their dividends for at least 25 consecutive years, actually enjoyed a total return of nearly 137%*.
 
So why should this be?
 
The concept of compounding, where the reinvested income from an asset itself grows over time, leads potentially to bigger and bigger returns. Companies that grow their dividends year on year typically observe a responsible approach to capital management, which their competitors may lack. They carefully invest capital into projects that are managed responsibly.
 
The discipline of paying a dividend to investors forces them to be careful with their capital. In short, a long-term pattern of rising dividends can often be the outward sign of robust internal capital discipline and may indicate a sustainable investment opportunity.
 
Traditionally, however, many investors have simply chased yields (the amount of income an investment delivers after charges) with a view that ‘the higher the yield, the better the return’. A high dividend yield can be a sign of a company in distress, when the share price has collapsed, rather than a signal of a healthy company with good long-term prospects.
 
A recent example of how disastrous a strategy of focusing only on high yields can be was in 2008, when those who took this approach may have bought shares in certain banks that were yielding more than some savings accounts. However, this proved to be a huge mistake as the share prices of many banking stocks subsequently collapsed and their dividends were cut – and as we all know, a number of banks did not survive the crisis.
 
A perhaps better approach for investors is to find companies which not only pay a respectable dividend today, but are able to grow their dividend over time and in a sustainable manner – to focus on the consistency rather than the size of the dividend.
 
In order to manage risk, diversification across sectors and regions is also a golden rule for investing. Most trends come and go, but it is experts who are best placed to exploit them successfully over the long term.
 
So what is, in our opinion, the key strategy to follow when seeking long-term investment success? Choosing the right adviser, who is able to best harness the expertise of the most effective fund managers in the market.
 
*Source: Mergent’s Dividend Achievers, as at 31.08.11; Datastream as at 30.09.11. Dividend achievers are US companies with a 25 year track record of consecutive dividend growth.

Paul Dickson
Managing Partner

 

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