Regular returns to shareholders from equity investments are often known as “ordinary dividends”. This is a misnomer – there is nothing ordinary about dividends at all. In fact, they are extraordinary! Here’s why…
Powerful evidence, gathered over a very long period of time, demonstrates that dividends, and the reinvestment of dividends, represent the dominant source of long-term real returns in stock markets around the world. Even without the impact of dividends, equities have delivered an attractive historic long-term return. The light red line below illustrates that $1,000 invested in the US stock market in 1900, would now be worth in excess of $15,000 in real terms (i.e. after the erosive impact of inflation has been taken into account).
But if you include reinvested dividends in the calculation, the total return from US equities is simply staggering. The dark red line illustrates that, with dividends reinvested, $1,000 committed to US equities in 1900, would now be worth $193,700 in real terms.
Compounding a higher number
This is what Albert Einstein called “the eighth wonder of the world” – the power of compounding. Small amounts, reinvested year, after year, after year, turn into very substantial sums in the long run.
The investment approach we adopt for the RWC Global Equity Income Fund insists upon a premium yield. We will only invest in stocks if they yield at least 25% more than the yield of the global stock market. The power of compounding dividends through time dominates everything else in the world of investment – and our yield discipline ensure that our fund will be compounding a higher yield than the market.
For example, the average yield on the FTSE World Index over the last five years is 2.45%. Our yield discipline means we will only buy stocks that are yielding at least 25% more than this yield – so the minimum yield at which we would have bought stocks over the last five years is 3.06%. The additional return that we receive from this premium yield is important and, as the chart below demonstrates, over long periods of time, it can be very significant. All else being equal, if the index delivers a 2.45% yield annually, after five years investors would have seen a 12.9% return of their original investment from income alone. However, if a fund delivers a 3.06% yield annually, the return from income after five years would be 16.3% of their original investment.
The power of compounding means the difference between these two numbers grows more substantial over time. After ten years, the comparable numbers are 27.4% for the index, 35.2% for the fund. After 20 years, the income returns from the index and fund are 62.3% and 82.8% respectively.
It is important to point out that these numbers are theoretical and there are many variables which will combine to ensure that an actual investment experience never exactly replicates these returns. Indeed, there are other sources of return, such as dividend growth and valuation changes, which should mean that the long-term returns delivered by an equity portfolio are even more attractive.
However, the numbers should be helpful in demonstrating that consistently compounding a higher yield than the market, can have a profound effect on returns over longer time periods. This is what we mean by compounding a higher number over time, and by only buying stocks with a premium yield, it is exactly what we intend to do.
Dividends drive better behaviour
The discipline of a dividend improves future earnings growth
This research focused on US companies, but other studies have concluded that the same relationship holds true in other regions. In turn, this suggests that investors in a dividend strategy should not only receive an attractive yield, they should also be rewarded with superior long-term growth. Indeed, we regard the dividend as much more than just a component of the overall return delivered by a stock. The regular payment of a dividend also represents:
- Tangible evidence of a company’s profitability
- An alignment between management’s interests and those of its shareholders
A reflection of a management team’s confidence in its future
- A sign that a company understands the importance of effective capital allocation and an appropriate balance sheet structure
For all of these reasons, we believe that the payment of a regular dividend is an important discipline for company management teams because it focuses their attention on effective and sustainable capital allocation.
A less volatile source of returns
As we have explored above, the dividend is highly prized by both shareholders and management teams. Neither party likes to see a dividend cut. As investors, we try to avoid them by focusing our research activities on the sustainability of a company’s cashflows, to ensure that the businesses we invest in have the ability to suffer without compromising their future dividend payments. And management teams try to avoid dividend cuts by investing in their business to deliver future growth without over-stretching themselves.
These disciplines are important, because they tend to make dividend income a less volatile source of returns. Dividends are a return on an investment in equities, so a fund that deploys a dividend-focused strategy will inevitably be exposed to the daily ups and downs of the stock market. However, it is unlikely to see the same degree of volatility as the broader market because the dividend itself is a much more stable source of returns.
The enduring appeal of dividends
Investors have sounded the alarm bell around the extreme valuations of technology stocks and other parts of the market that display classic ‘growth’ characteristics. Many people believe we are in bubble territory and have questioned the sustainability of share prices and earnings from the parts of the market that have driven returns in recent years.
Within equity markets, therefore, dividend-oriented strategies look less risky because they have not witnessed the same level of excitement and enthusiasm. Valuations, as a result, are much more attractive, and our yield discipline ensures we will only invest in stocks that offer a premium yield to the market.
We believe that by focusing our investment approach on the statistical power of dividends, we are explicitly targeting the dominant source of long-term real returns and naturally tilting the portfolio in favour of efficient capital allocation and long-term growth. This is the power of dividends and we aim to harness it on your behalf.