Anybody scanning the share listings in the Financial Times will note that there are seven columns next to each company name. While most criteria shown are intuitive, the sixth column contains a familiar, but often misinterpreted metric, which is frequently used to gauge the relative cheapness of a stock.
The price/earnings (P/E) ratio is useful because it tells us how long, in years, it will take us to recoup the capital outlay of buying a stock in accrued earnings – the bigger the number (or multiple), the more expensive the stock. The problem with the P/E ratio is that it is completely intangible. Investors do not actually receive the earnings yield and although ‘retained earnings’ are theoretically invested into the enterprise to the benefit of the end investor, this is not the same as compounding a dividend yield over time.
The above quote demonstrates that Albert Einstein would approve of the concept of reinvesting dividend income. While it is unquestionably the case that the short-term performance of an equity portfolio is driven by share price moves, long-term returns are influenced by reinvested income.
By virtue of the power of compounding reinvesting dividends makes a huge difference. For example, a UK equity portfolio, which started life at the beginning of 1965 with an initial investment of GBP 1, would have ended 2016 with a value of GBP 50, even without reinvesting dividends. This was ahead of inflation, leading to a real capital gain of 1.9% every year. Now, adding in reinvested dividends leads to a real capital appreciation of 6.3% per year. Or put another way, that same pound would be worth GBP 445.
The gains from the two different approaches are shown in the graph below. This plots the cumulative return from UK equities both with and without reinvested dividends.
Impact of reinvested dividends on cumulative UK equity returns, 1965-2016
Along with the fact that dividends are frequently the main contributor to total returns, they also become more meaningful the longer the holding period. Over an average holding period of one year, dividends account for 31% of total returns of the UK market. Over a three year holding period this rises to 36%, five years to 40%, ten years to 49% and 20 years to 63%.
This is a powerful conclusion, and one that in recent times has been overlooked as investors have chased quick profits by concentrating on short-term strategies. By taking a disciplined long-term approach, fund managers can differentiate themselves from the herd and add real value for their investors.
In addition, there are three further points worth noting. First, dividends as a proportion of total returns vary considerably across each time period. Second, dividends become more important in lower growth periods, in times of heightened volatility and in down markets. Third, unless it is entirely unavoidable, corporate chiefs tend to be reluctant to cut dividend payments, which means that dividends act as a cushion during difficult periods.
The dividend yield premium over government bond yields is considerable, particularly when viewed in a historical context. Even if dividend growth proves to be lower than expected, the reluctance of the Bank of England to raise rates, thus keeping a lid on bond yields, supports the case for UK dividends.
Furthermore, at a time when pensioners have greater freedom over how to invest their savings, and with annuities rates so low, there is a case to be made that a greater proportion of pension assets should be allocated towards companies capable of funding reliable dividends.
FTSE All-Share forward dividend yield and 10-year gilt yield since 1986
Over the longer term, following a dividend-oriented strategy is compelling. Nevertheless, it is crucial to consider the sustainability of the dividend and whether or not it can grow. If not, then inflation will inevitably erode the value of that income over time. Focusing on those companies with robust balance sheets and strong cash flow profiles helps to protect against this. Furthermore, buying such companies when they trade at a discount to their intrinsic value minimises the chance of overpaying. As such, we believe that a strategy delivering returns from two sources, namely prospering income streams and capital returns generated by the share price of undervalued companies rallying, has the potential to materially outperform.