In today's volatile markets, being dull has its virtues. Any capital growth you enjoy today could be snatched back tomorrow, but nobody is going to take away your dividends.
Dividends, not growth, should be what investors focus on
Too many investors suffer from a deadly fixation. Growth, that's all they think about. If they buy a stock or fund, they dream of seeing its price double or triple in value.
That means they overlook what really drives consistent long-term profits. Dividends.
The obsession with growth reached a peak in the dotcom bubble of the late 1990s, when investors were dazzled by technology stocks that promised to quadruple or quintuple in months or even weeks. In all the excitement, dividends seemed dull.
In today's volatile markets, being dull has its virtues. Any capital growth you enjoy today could be snatched back tomorrow, but nobody is going to take away your dividends. They're yours to keep.
And in the long run, that's where you will make much of your money, especially if you reinvest them.
In the 10 years to January 31, 2012, the US S&P 500 Index grew a mere 18 per cent. Once you include reinvested dividends, the total return more than doubles to 44 per cent.
The impact is even greater in the UK, where dividend payouts have traditionally been higher. The FTSE 100 grew just 11 per cent over the past decade, but its total return, including dividends, was nearly 60 per cent.
The past turbulent 12 years have been a growth disaster, with markets still well below the highs they hit on December 31, 1999. But it has taught us to respect the power of the dividend.
Dividends are a portion of profits that companies pay to investors as a "thank you" for holding their shares. In most cases, the dividend is paid as cash, typically every quarter. By paying an attractive dividend, the company hopes to boost demand for its shares - and boost the price.
Companies often pay dividends to compensate for the fact that they are no longer growing strongly. Mature global blue chips such as Coca-Cola and BP, the oil major, passed the rapid growth stage long ago, but they can still seduce investors with a steady flow of dividends.
Large, solid companies with a reliable earnings stream tend to pay the most solid dividends. Pharmaceutical companies such as GlaxoSmithKline or Roche typically do. Tobacco companies and utilities also do. Whizzy biotechnology start-ups don't. They need to plough their earnings back into the business.
Dividends have always mattered, says Richard Turnill, the head of global equities at BlackRock, the asset manager. "Sometimes people forget about them, as they did in the late 1990s, but, historically, they make up around 40 per cent of your total investment return."
Today, they matter more than ever. "How do you generate attractive returns in today's low-growth environment? Dividends. How do you make consistent returns in these volatile markets? Dividends. How do you beat low interest rates? Dividends," Mr Turnill says.
When comparing dividends, the key word is "yield". This is what you get when you divide the dividend by the price of the stock. So, if the annual dividend is US$1 (Dh3.67) and the stock trades at $20, the yield is 5 per cent. If the company hits trouble and its share price halves to $10, the yield doubles to 10 per cent. Plenty of household names yield between 4 per cent and 6 per cent, a far better return than you will get on cash.
Some stocks can yield as much as 9 per cent or 10 per cent, but approach them with caution, Mr Turnill says. "We are nervous about buying very high-yielding stocks. It is often a signal that the underlying company is in trouble and could struggle to maintain that dividend. We prefer companies with more sustainable dividends. They typically offer the best returns over time."
Companies are free to cut their dividends whenever they wish. Some major companies have been forced to scrap their dividends altogether, including many banks during the financial crisis and BP after the Deepwater Horizon drilling disaster in the US (it has since restored its dividend).
Cutting your dividend tells the market your business is in trouble, Mr Turnill says. "That's why companies work hard to maintain or increase their payouts, which is one of the big attractions of dividend investing."
Dividends also offset some of the dangers of investing in the stock market. "If you are buying a company yielding 5 per cent or 6 per cent, you will get a compound return of around 30 per cent over five years. That gives you plenty of protection against investment risk."
Good dividend payers are often called "defensive" stocks because they are typically solid, reliable companies that can reduce the risk profile of your portfolio.
The UK and Europe are a good source of dividends, but the US and Japan are steadily catching up, Mr Turnill says. "Dividends are also rising in emerging markets across Asia and Latin America. Even companies in the technology and industrial sectors are now starting to pay dividends. Taiwan Semiconductor Manufacturing yields nearly 3.7 per cent, while industrial company Consolidated Edison yields more than 4 per cent."
You can also chase yield by investing in a mutual fund from the equity-income sector. This reduces the risk of a company share price blowout by spreading your money between 30 to 50 dividend-paying stocks. Equity income funds typically yield between 3 per cent and 5 per cent a year, plus any capital growth if share prices rise.
With investment growth set to slow as the world concentrates on paying down its debts, dividends offer some compensation, says James Harries, the manager of the Newton Global Higher Income Fund, which yields about 4.7 per cent by investing in global behemoths such as Reynolds International, Philip Morris, Bayer, Pfizer and Procter & Gamble. "We expect to see shorter and more volatile business cycles and fairly low returns from financial assets. In these conditions, we are focusing on robust, durable and well-financed companies that pay dividends."
With savings rates so low, dividends offer some respite for older investors who need to generate income from their investments, says Martin O'Hare, the head of investment solutions at Signia Wealth, the fund manager. "Now is a great opportunity to buy high-quality companies at extremely attractive yields," he says. "Many companies are generating strong cash flow and are increasing their dividend payouts, which will help your income grow in line with inflation."
There are plenty of good UK-listed stocks to choose from, including Royal Dutch Shell, which yields 4.6 per cent, British Land (5.3 per cent) and Aviva (7.2 per cent). "Or you could buy an exchange-traded fund such as the iShares FTSE 100 tracker, which yields 3.1 per cent or iShares FTSE UK Dividend Plus, which yields 5.1 per cent," Mr O'Hare says.
US companies also offer attractive yields, such as Coca-Cola (2.8 per cent), AT&T (5.8 per cent), Merck & Co (4 per cent) and Intel (3.1 per cent). "If you prefer to spread your risk, a tracker such as iShares S&P 500 Index currently yields 2.3 per cent," Mr O'Hare says.
If you don't need the income, reinvesting your dividends gives your capital growth a real boost, says Dan Dowding, the chief executive at IFAs Killik & Co in Dubai.
"If you invested $1 into the US equity market in 1900, it would be worth $217 in 2010, an annualised return of 5 per cent. If you had reinvested your dividends, you would have $21,766, an annualised return of 9.4 per cent."
The longer you invest, the more dividend income matters. "Look for companies that have a history of paying a rising dividend because they are likely to outperform the market," Mr Dowding says. "Companies that commit to deliver a growing dividend are forced to focus on sustainable cash flow and long-term earnings growth. This discipline is good for the business."
So drop that outdated fixation with growth and learn to appreciate the charms of the dividend. In the long run, that's where most of the growth is.
Dan Dowding, of Killik & Co in Dubai, recommends the following top equity-income funds:
Invesco Perpetual Income
This fund has been managed by Neil Woodford since October 1990 and has a strong long-term track record. It offers income and capital growth from a portfolio of UK and international equities. “Woodford is contrarian by nature and his portfolio tends to differ markedly from a typical UK equity-income fund. He backs his views with conviction and has delivered for more than 20 years,” Mr Dowding says
Top holdings GlaxoSmithKline, AstraZeneca, Reynolds American, Vodafone, British American Tobacco, Roche, Imperial Tobacco and Reckitt Benckiser
Yield 3.82 per cent
Three-year return 36 per cent
This fund, from Troy Asset Management, offers above-average income with capital growth from a mix of UK and international equities
Top holdings Vodafone, Royal Dutch Shell, Imperial Tobacco, British American Tobacco, BP, AstraZeneca and Unilever
Yield 4.37 per cent
Three-year return 47 per cent
Veritas Global Equity Income
This fund invests in solid global companies and targets a yield that is 15 per cent higher than the FTSE All-Share Index over a rolling five-year period
Top holdings PetroChina, Roche, GlaxoSmithKline, HSBC, Telstra, Eni, Vodafone, Lockhead Martin, StatOil, MTN Group
Yield 4.81 per cent
Three-year return 59 per cent
SPDR S&P US Dividend Aristocrats
A “dividend aristocrat” is an equity that has increased its dividend for at least 25 consecutive years. This ETF tracks the performance of the S&P High Yield Dividend Aristocrats Index, which has strongly outperformed the S&P 500 Index
Top holdings Pitney Bowes, AT&T, Cincinnati Financial, Johnson & Johnson, PepsiCo, Procter & Gamble, McDonalds, Coca-Cola, Colgate-Palmolive, Walmart and ExxonMobil. The fund was launched in October 2011 and doesn’t yet have a full year’s dividend history
Yield 3.9 per cent