'
August 19, 2019
How Important is Dividend Yield?
growth

Dividends are far more than just a coupon received every six months as some sort of reward for being a shareholder in a company. They should be a critical component of any investors’ strategy.

At Ophir we focus on companies that can meaningfully grow and compound earnings over time. We are looking for companies that have high rates of return on incremental capital they invest in their business. Consequently, our preference is for companies to invest surplus cash they generate back into their business to grow future earnings. However, in instances where large cash surpluses are generated and it doesn’t make sense for the company to reinvest back into the business, we want these to be paid out to shareholders via dividends.

For some investors dividends are merely a coupon received every six months as some sort of reward for being a shareholder in a company. In fact, dividends are far more than just this and should be a critical component of any investors’ strategy for four primary reasons:

  1. The significant contribution dividends make towards total returns.
  2. The information content of dividends in steering investors towards “quality” companies.
  3. Dividends as a growing source of income in today’s low interest rate world.
  4. The franking credit boost investors can receive from dividends.

Dividends Drive Total Shareholder Return

One of the most common traps which share market investors fall into is narrowly focusing on share price changes as the primary gauge of portfolio performance. Admittedly, this is an easy habit to slide into as newspapers, television and even broker reports heavily skew attention towards price moves. The reality, however, is that the actual return investors receive is a product of multiple factors ranging from taxes to transaction costs. Standing out above these are dividends.

Combining share price returns with dividends paid gives the ‘total return’ of an investment. And by using this measure we are able to avoid incorrectly penalising the equities that generate a higher proportion of their total return through dividends. A clear illustration of this is presented in the charts below, which compare the performance of the Australian and US equity markets. On the left hand chart we see price returns, a measure which shows US equities to have delivered a 5.7% return p.a. since 1997, versus only 4.5 % p.a. over the same period from Australian shares.

A very different story emerges when we compare the two markets using total returns. On this measure Australia shares returned 9.0% p.a. against just 7.7% p.a. from US stocks. The contrast is stark. When measured only on price Aussie shares have lagged their US counterparts. However, by including dividends Australia shows itself to have generated superior returns.

Dividends Can Identify Quality Companies

As well as being a significant contributor to total returns, the information content of dividends can also tell investors a lot about individual companies. For example, given that corporate managers are generally reluctant to increase dividends unless they believe it can be sustained at the new level, dividends are a good barometer on the quality of earnings. Put another way, by committing to pay a dividend managers can help convince investors of their firms’ long-run earnings sustainability.

Similarly, strong stable dividend yields, and or consistent growth in dividend per share, are usually associated with companies which are able to generate a high ROE, maintain strong margins, and display a high level of transparency in their earnings.

Dividends in Today’s Low Interest Rate World

Although it may be hard to imagine, until just 25 years ago it was relatively easy to find government bonds yielding over 10%. Now you will have trouble finding many yielding more than 2%. For policymakers this decrease in interest rates reflects a success in the form of inflation no longer being the problem it once was.

For investors it’s a different story. Previously they could live off the yield from bonds, whereas now that income is a fraction of what it once was. To meet this challenge investors have rotated their portfolios towards dividend from stocks as an important source of income.

Not surprisingly this appetite for yield has prompted a response from companies. Across sectors there has been a trend to allocate a higher proportion of earnings towards dividends. As well as this step up in payout ratios, stock buybacks are now regularly used by many companies as another form of returning capital to shareholders.

Franking Credits

Finally, franking credits, whereby the shareholder receives a credit for tax the company has paid above your top tax rate add further to the importance of dividends. The boost from franking credits can mean many investors achieve an effective dividend yield of 6.5% on their equity portfolios.

Thinking Ahead

Although we believe dividends are a key foundation of any investor’s portfolio, this does not mean that holding stocks which pay the highest dividends is a shortcut to better returns. Unfortunately many of the highest dividend yielding companies are actually those which are most likely to cut their dividends. The share price reaction to such dividend cuts is usually severe. To avoid these “value traps” investors need to perform detailed bottom-up analysis on businesses so as to ascertain how safe and sustainable a particular company’s dividends actually are.

As it happens, the rise of income investing has been quite a comfortable transition for most Australian based investors. The existence of franking credits, a high level of individual stock ownership, plus the sheer weight of banks have always meant the Australian equity market stands out as a source of dividends. Going forward, as interest rates fall further or if the global economy wobbles, the strong and steady dividends which large cap Australian companies pay should provide much needed insulation in investor portfolios.

Category:

Get our latest insights

By subscribing to Ophir News & Insights you'll understand more about our investment philosophy and process and the investment decisions we make on all of our behalf.


What You'll Get

  Monthly Ophir Letter to Investors
  Timely investment ideas
  Exclusive event invitations