The ability of a company to pay out steady or growing dividends is often a sign of a healthy business and a good long-term investment. These dividend payments can play an important role for investors.
A dividend is a payment made by a company to its shareholders and typically represents a portion of a company’s earnings that the directors of a business have decided to pay out and not reinvest back into the company.
The benefits of dividends
1. A source of income
Dividends provide investors with cash flows which can be used to fund lifestyle requirements, or they can be reinvested. It is interesting to note that in first-world markets at present, dividend yields of multinational blue-chip companies are higher than cash and bond yields, making them an excellent source of current income.
The chart below compares the yields of a selection of multinational blue-chip companies to the 10-year US government bond yield:
2. Inflation protection
Companies that pay dividends provide investors with an effective inflation hedge. Take, for example, an investment made in Clicks. In 2000, R100 000 would have bought the investor 7 905 shares in the company. Those shares would have paid the investor approximately R1 400 worth of dividends in the first year. In 2018 that same investor would have received approximately R30 000 worth of dividends from the same number of shares.
This increase in dividend income equates to an average annual income growth rate of 18.6% per annum for the past 18 years.
This growth exceeded average inflation over the corresponding period by 13.2% per annum.
It is also important to note that the value of a company increases at the rate at which its profit grows. In the same way, over time the value of an investment grows at the rate at which its income grows. Clicks’s average annual capital growth over the last 18 years has been 16%, which corresponds with the company’s 19% average annual growth in dividend over the same period.
The chart below illustrates Clicks’s dividend and share price growth since 2000:
3. Companies that reliably grow their dividends tend to outperform the market over time
Many investors think of reliable dividend payers as stodgy, uninteresting companies that will produce mediocre returns. This is far from being the case. Studies have shown that companies which pay and grow their dividends outperform the market over the long term.
The table below highlights the relative outperformance over the last 20 years of some of the world’s best dividend-paying stocks when compared to the S&P 500 Index.
Possible explanations for why reliable dividend payers outperform include:
- The inherent optimism that drives investors to overpay for exciting and high-risk companies with volatile dividends and underpay for certainty
- The large percentage that dividend income contributes to an investor’s total return over the long term, and
- The fact that reliable dividend growth typically indicates that a company has a dominant brand, a strong balance sheet and a high degree of confidence that its earnings and cash flows will continue to support future payments.
4. Managing tax
In South Africa, dividends are taxable in the hands of the investor at a flat rate of 20%. This is an advantage for high-net-worth individuals in higher tax brackets.
Investing in companies that pay reliable dividends helps reduce volatility – when the company’s share price declines, the investor will still receive dividend payments.
The Marriott Dividend Growth Fund is a local equity fund that demonstrates the value of this strategy. It has achieved average distribution growth of 11% each year since 2000, exceeding inflation by approximately 5.6% per annum, by investing in fundamentally sound JSE-listed stocks that have the ability to pay consistent dividends.
Preston Narainsamy is an investment professional at Marriott.