Why are div­i­dends so im­por­tant to eq­uity in­vestors?

Shares - - INVESTMENT TRUSTS -

In­come fund man­agers con­stantly bang on about div­i­dends. Maybe it’s in our ge­netic makeup but ac­tu­ally div­i­dends should be im­por­tant for all eq­uity in­vestors. David Smith, fund man­ager of Hen­der­son High In­come Trust, shares his five key rea­sons for this:

1) TO­TAL RE­TURNS

I can bore you by recit­ing data from nu­mer­ous stud­ies show­ing div­i­dend yield and div­i­dend growth make up the ma­jor­ity of an in­vestor’s to­tal re­turn over the long run but it would be more in­ter­est­ing to look at a real time ex­am­ple. I bought Im­pe­rial Brands for Hen­der­son High In­come Trust 5 years ago when the stock was trad­ing on an 11x price to earn­ings mul­ti­ple. To­day the mul­ti­ple is still at 11x. The mar­ket is valu­ing the com­pany at the same rat­ing it did 5 years ago. So does that mean the com­pany has been a bad in­vest­ment? In short, No. The shares have de­liv­ered a to­tal re­turn of 64%, out­per­form­ing the UK eq­uity mar­ket by over 20% in that time pe­riod. That re­turn has been driven by the high div­i­dend yield which has grown at 10% p.a. Mes­sage 1 – you don’t need a rerat­ing for shares to out­per­form.

2) CON­TRAR­IAN IN­VEST­ING

Gen­er­ally high yield­ing stocks tend to be un­fash­ion­able as ei­ther they have dis­ap­pointed the mar­ket, re­sult­ing in a fall­ing share price/ris­ing yield, or they are ma­ture, low growth busi­nesses. Con­se­quently, in­vestors ei­ther un­der­es­ti­mate their abil­ity to pro­duce de­cent re­turns or as­sign a too low val­u­a­tion to th­ese re­turns. Back in 2012 As­traZeneca had a div­i­dend yield of 7% but was fac­ing a patent ex­piry on its main drug, was unloved by an­a­lysts, was per­ceived to have no new drugs in its pipe­line and peo­ple ques­tioned the div­i­dend sus­tain­abil­ity. Not a com­pelling in­vest­ment case. Since then the com­pany has com­mit­ted to the div­i­dend, de­vel­oped a pipe­line full of ex­cit­ing im­muno-on­col­ogy drugs which are the envy of the in­dus­try and the shares have re­turned 186%. Mes­sage 2 – Just be­cause a com­pany is out of favour doesn’t mean it can’t change.

3) IN­VESTOR DIS­CI­PLINE

Fund man­agers love to talk through their in­vest­ment process and how it led them to buy a par­tic­u­lar stock but fre­quently skip over their sell dis­ci­pline. A fo­cus on div­i­dend yields pro­vides a clear val­u­a­tion dis­ci­pline for fund man­agers. When the div­i­dend yield of a stock moves to a discount to the mar­ket, through strong share price ap­pre­ci­a­tion, it forces the fund man­ager to re-eval­u­ate the in­vest­ment. Can I still jus­tify hold­ing a low yield­ing com­pany as an in­come fund man­ager? The an­swer is some­times. Hil­ton Food Group now yields only 2.3% hav­ing been one of my strong­est per­form­ers over the last few years, how­ever, given the good vis­i­bil­ity over its fu­ture growth it still has a place in the port­fo­lio. When MoneySu­perMar­ket’s div­i­dend yield fell to less than 3% in 2015, the pay­out ra­tio was al­ready high while the rate of growth was slow­ing. De­spite be­ing a good per­former it was time to move on. Mes­sage 3 – Stay dis­ci­plined even with your favourites

4) COM­PANY MAN­AGE­MENT DIS­CI­PLINE

Com­pany man­age­ment’s role is to keep us share­hold­ers happy. One way is to pay a sus­tain­able div­i­dend while the other way is to in­vest and grow the busi­ness. It’s a fine bal­ance in cap­i­tal al­lo­ca­tion. Pay­ing a too small div­i­dend may lead to the cash flow burn­ing a hole in man­age­ment pock­ets and en­cour­age them to spend it ir­re­spon­si­bly. Think Rio Tinto’s $38bn ac­qui­si­tion of Al­can in 2007. Pay­ing a too big div­i­dend may con­strain in­vest­ment in the busi­ness and lead to is­sues in the fu­ture.

Bus and Rail op­er­a­tor FirstGroup cut cap­i­tal ex­pen­di­ture to main­tain their div­i­dend which ul­ti­mately led to an un­der­in­vested fleet, op­er­a­tional prob­lems, a div­i­dend cut and a rights is­sue. Mes­sage 4 – A high div­i­dend yield is not al­ways at­trac­tive espe­cially if the com­pany can’t af­ford it.

5) CASH FLOW

Com­pa­nies are un­able to pay div­i­dends with­out suf­fi­cient cash flow. Cash flow is harder to ma­nip­u­late than earn­ings and pro­vides a bet­ter in­di­ca­tion of a com­pany’s value. Be­fore Car­il­lion got into trou­ble the val­u­a­tion used to screen “cheap” on earn­ings met­rics but the com­pany al­ways gen­er­ated poor cash flow. This should have been the early warn­ing signs to in­vestors. Mes­sage 5 – Don’t ig­nore the phrase “Cash is King”

Div­i­dends are very im­por­tant to in­vestors but only if they are sus­tain­able and can grow into the fu­ture. Fo­cus­ing on a well-di­ver­si­fied port­fo­lio of com­pa­nies that pay a good and grow­ing div­i­dend should help drive out­per­for­mance over the long term.

Noth­ing in this doc­u­ment is in­tended to or should be con­strued as ad­vice. This doc­u­ment is not a rec­om­men­da­tion to sell or pur­chase any in­vest­ment. It does not form part of any con­tract for the sale or pur­chase of any in­vest­ment.

Past per­for­mance is not a guide to fu­ture per­for­mance.

The value of an in­vest­ment and the in­come from it can fall as well as rise and you may not get back the amount orig­i­nally in­vested.

Is­sued in the UK by Janus Hen­der­son In­vestors. Janus Hen­der­son In­vestors is the name un­der which Janus Cap­i­tal In­ter­na­tional Lim­ited (reg no. 3594615), Hen­der­son Global In­vestors Lim­ited (reg. no. 906355), Hen­der­son In­vest­ment Funds Lim­ited (reg. no. 2678531), Al­phaGen Cap­i­tal Lim­ited (reg. no. 962757), Hen­der­son Eq­uity Part­ners Lim­ited (reg. no.2606646), (each in­cor­po­rated and reg­is­tered in Eng­land and Wales with reg­is­tered of­fice at 201 Bish­ops­gate, Lon­don EC2M 3AE) are au­tho­rised and reg­u­lated by the Fi­nan­cial Con­duct Au­thor­ity to pro­vide in­vest­ment prod­ucts and ser­vices.

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