IN DIVIDENDS we trust
The investment case for equity income has been well documented over the years by both academics and industry participants. Over the long term, the main driver of equity returns has been the dividend yield and dividend growth. The real return from European equities has trended around 7% per annum, according to data that goes back to 1926, with dividend yield and growth contributing significantly to the total return. This is borne out by the fact that high yielding stocks have outperformed the broader market over the last 23 years in all of the major equity markets, as can be seen below in Figure 1.
Figure 1
The second chart (Figure 2) is taken from a paper by Societe Generale and shows the decomposition of returns over the last 40 years for various major equity markets. This chart clearly shows that dividend yield and dividend growth make up the majority of investors’ returns over that period. So the question is can investors expect to see similar returns going forward?
Figure 2
So, in summary, dividends have been the most important driver of equity returns over the long term. Over the last 25 years, almost all of total returns from UK equities have come from dividends (yield & growth).
Source: SG Quantitative Research. The chart shows what percentage of normal returns come from the change in valuation, dividend growth and dividend yield. As at 31 August 2010.
During the secular bull market of the 1990’s, the long term decomposition of long term returns was reversed with the increase in share prices making up the majority of shareholder returns. Over the first few years of the 2000’s however, dividend yield has been the only source of real return for investors. In reality it is only since the end of the last bear market 2003 that the contribution of dividends to real returns has increased once more and that contribution now exceeds the long term average.
The recent Q2 2011 dividend report by Capita Registrars made much of the sharp rise in dividends from UK companies in the 2nd quarter of this year. It highlighted that growth came from across the board with cyclical sectors raising their dividends by 35% on average, while the more defensive sectors raised theirs by 13% on average. The strength of UK corporate earnings, rebuilt balance sheets and strong cash flow generation has allowed companies to both maintain, and in many cases grow, their dividends.
UK equities currently offer a prospective yield of around 3.6% (Source: Bloomberg as at 28th July 2011) and are attractively valued versus their history and versus their developed international peers, offering a dividend yield higher than both the US and Japanese equity markets. While companies are beating profit expectations, we are confident that dividend yields will be maintained – providing consistent returns for investors and those seeking higher yields.
Given the uncertainty that still surrounds the Eurozone, where can investors put their money to work, with the comfort of knowing their income isn’t going to be drastically reduced should the sovereign debt crisis develop into another banking crisis, forcing Finance Directors to hoard cash for their companies? One solution might be to look at Investment Trusts which have a unique feature and benefit from their structure - the ability to build a revenue reserve which can be drawn upon should the economic and corporate environment dictate.
The JPMorgan Claverhouse Investment Trust, which aims to provide capital and income growth from a portfolio of predominately large cap UK companies, is one such company. The company has raised it’s dividend by at least the rate of inflation every year since 1972 and currently yields 3.8%. The company has increased its dividend by 124% over the last 10 years and despite drawing on its reserves in recent years still has dividend reserves of 0.9x.
For those looking for more capital growth from their portfolios, combined with an attractive yield, the Mercantile Investment Trust, whose objective is to provide long term capital growth from a portfolio of UK medium and smaller companies, also has a strong track record of growing it’s dividend. The company has increased its yield by 143% over the last 10 years and currently yields 3.4%, while retaining dividend reserves of 0.6x. Both companies currently have a significant yield premium to the 10 year Gilt and both retain a substantial revenue reserve, which they have historically and could continue to draw on in the future should the underlying portfolio fail to deliver enough income on its own.
With bank rates at an all time low we believe income-hungry investors will continue to look at alternatives to generate the income they need and are not getting from cash. With the climate of low interest rates likely to persist and uncertainty surrounding the markets as a result of the sovereign debt crisis, a long term investment in an income producing investment trust that has reserves enabling the company to smooth returns to investors over time could be the answer.
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