In any equity portfolio dividends can be a big part of the total return. It makes simple sense that if you are able to earn and reinvest dividends over a significant period of time, you are compounding your growth.
However, it’s not always as obvious how investors should treat dividends. Should a good dividend yield be a prerequisite to choosing a stock, or is it just an added bonus?
The truth is that different investors will have different requirements, but there are good reasons for adding dividend-paying stocks into any portfolio.
“Dividends can be an important and certain contributor to total return,” says Duggan Matthews, investment professional at Marriott. “If you are investing in companies with a consistent dividend yield, that is a certain element of growth that you can know upfront.”
The second reason for looking for companies that pay good dividends is that often this is an indication of the quality of the business.
“Companies that pay good dividends tend to be more stable and more mature, so it could also be an investment premise for the investor who is looking for higher quality companies,” says Nerina Visser, strategist at etfSA. “Then it’s not so much abut the dividend as the quality of the underlying stock.”
Finally, dividends can be important for investors looking for income.
“For a lot of investors post retirement, dividend-paying stocks can be useful in terms of providing for their living expenses,” says Matthews. “If you look internationally at the moment, you have a situation where 10-year bond yields in the US are at 1.5%, but you have a company like Coca-Cola that hasn’t cut its dividend in 50 years yielding 3%. So you can get more income from dividend-paying companies than from bonds, and that is appealing to retired investors.”
Recent underperformance
Investing in dividend payers therefore seems like a pretty solid strategy. Yet over the last 18 months to two years some dividend strategies have not always delivered such great returns.
The FTSE/JSE Dividend Plus Index has lagged the All Share quite substantially, and has delivered a negative return over the last year. Some well-known unit trusts focused on dividend-paying stocks have also underperformed.
It is worthwhile for investors to appreciate why this is, because it also helps them to understand what they might be getting when looking at dividend paying stocks.
The first thing to consider is that while a high dividend yield can be a sign of value in a stock, it could also be a red flag. The yield may have gone up because the price of the share has fallen due to serious underlying problems. Investing purely on the basis of a high yield has therefore come with potential pitfalls at a time when economic conditions are tough.
“A very high dividend yield could be a warning sign that the growth outlook for that company is under pressure or there are concerns over the sustainability of that dividend,” Matthews explains. “So we tend to shy away from the very high yielders unless we think that the market is being unreasonable in its assessment of the company’s longer term prospects.”
It can also happen that companies in cyclical industries pay out high dividends at the top of the cycle, but as conditions change those dividends will be impossible to sustain. Some mining companies are good examples of this. Kumba Iron Ore paid out some generous dividends between 2011 and 2014, but then suspended its dividend entirely last year after the price of iron ore collapsed.
The second challenge that dividend strategies have run into is that a number of the JSE’s most stable dividend payers are financial stocks like banks and insurance companies. These are the counters that have been hardest hit by the external factors of Nenegate and Brexit.
What is important to note in this case though, is that while investors have seen capital losses in these stocks, the ability of these companies to pay dividends has not seriously been affected.
“If you were selecting these companies on the basis of receiving consistent dividends, then perhaps you should not be concerned about the price going up and down because you are still getting the flow,” Visser explains. “But if your investment premise is that you are looking for good quality companies, then you might have a bit of a problem when share prices come under pressure. Then it becomes a question of over what period are you measuring performance.”
In this case, Matthews says that even though the outlook for banks might not be great, there is still an argument to invest in them for their dividend-paying qualities.
“We don’t expect very good levels of dividend growth from banks going forward because the consumer is under pressure and taking on additional debt at a slow pace,” he says. “But that is reflected in the yields that are currently around 6%. So we are still happy to hold banks because you don’t need a very high level of dividend growth for that investment to produce an acceptable level of return.”
Source: http://www.moneyweb.co.za/investing/the-ups-and-downs-of-dividends/