Dividends the real deal
That’s why you should be buying shares
IT MIGHT BE HARD to believe anything good has come out of the past year of turbulent equity markets. But if there is, it’s the importance of dividends. Corporate earnings are all over the place, with share prices following. Dividend payments may well be lower in the coming year, as Finweek has pointed out. But dividends are the real deal – and even more powerful if reinvested.
Dividends are the reason you should be buying shares, older investors will tell you. The problem is that gets so quickly forgotten in a bull market when all the attention is on rising share prices. And when we reach bubble conditions you’ll notice the companies with share prices leading the upward charge often don’t pay dividends.
To an extent we saw it with some AltX listings. It was certainly true in the dot.com bubble. When such share prices lose half of their value that’s the hit the investor takes – without any compensation from dividends.
But for dividends to be an effective part of an investment strategy it should be longterm investing.
Andrew Kemp, head of research and investment management at acsis, has conducted some research to show dividends are one of the most powerful tools for investors serious about a long-term view. “More specifically, they’d discover the importance of reinvesting dividends,” Kemp says. His research looks at share price changes and total return on the SA market between 31 December 1960 and 31 December 2008. You can see the result in the graph, showing that over time the importance of dividends (reinvested as part of the total return) increases significantly.
Breaking down the total return shows the power of dividends reinvested. Over the period share price changes account for 45,6% of the total return, dividend payments 12,8% – but dividends reinvested 41,6%.
However, you’ll notice it takes time for the total return to start to pull away from share price movements – around 20 years in this case. But when reinvested dividends start to kick in, the difference in returns is dramatic.
However, Kemp points out investors might regard the timeframe in his example – almost 50 years – as being unrealistic. “Who has the luxury of such a long-time horizon?” he asks. While he acknowledges that’s true, he points to a different scenario. “A 40-yearold with limited savings invested 10% of his salary into equities from 1978 until his retirement age at 60 in 1998. His investment objective was to retire with a pension equal to 70% of his final salary in order to maintain his lifestyle.”
Plotting that outcome shows – assuming excess income not required to fund living expenses is reinvested – the income generated by the portfolio over time grows significantly faster than the retiree’s living expenses. “Importantly, the volatility of the dividend income is significantly lower than the volatility of the market prices,” Kemp says.
For the retiree that will take lots of the angst out of watching share prices go up and down while his portfolio is providing comfortably more than he needs to maintain his lifestyle.
Kemp says he’s not suggesting individuals should only invest in equities. Asset allocation remains important and should be done with professional advice. What he’s trying to show is the importance of reinvesting dividends over a long period. “That’s equally applicable to investors who invest via unit trusts as opposed to directly through shares.”
Kemp’s comments would apply to most equity or balanced unit trust funds. But take a look at how well a unit trust specialising in dividends has done. The Prudential Dividend Maximiser unit trust has been the best performing over the five years to end-December 2008, offering 25,4%/year. It would be difficult to find any long-term investment return that will beat that.