In principle, making money in the market is all about buying low and selling high. At least that's what most people tend to think, and a great deal of effort goes into trying to identify stocks with the best growth potential. However, while capital gains are indeed a fundamental aspect of building wealth in the market, they represent only half the story, literally.
Numerous studies have shown that over the long term, close to half of the total return from stocks comes from dividends. This alone suggests that investors would be foolish to ignore the humble dividend, but there are a variety of other compelling reasons as to why even the most aggressive of growth investors should consider the income potential of stocks.
Dividends are very dependable
Even a cursory glance at the market will tell you that it is a volatile place. A company's value can change substantially in a very short space of time, even when there have been no material changes to the underlying business. To many it is this very fact that makes the market so appealing; after all, sudden and significant changes give the potential for attractive short term gains for those of a speculative bent.
For those of us more concerned with investing though, this volatility represents a significant risk. If you hold only growth stocks that have never paid a dividend, and need to liquidate your holdings, the return you receive will be very sensitive to the mood of the market at the time. People who were planning on retiring recently know this only too well, with close to 50% of capital value being erased between late 2007 and mid 2009.
Such a massive correction isn't anything to worry about for those who can afford to wait for things to recover (and indeed represents an excellent buying opportunity), but for those expecting to live off their investments in retirement such an outcome is devastating. No one can predict when the next crash will hit or how significant the correction will be, so understand that if your strategy is completely focused on chasing capital gains you better ensure you are able to leave your investments untouched for many years.
But while a long term view will allow you to ride out any negativity, you don't receive any benefit whatsoever in the interim, absolutely none. You will only ever realise a gain when you sell, and again that gain will depend largely on market sentiment at the time.
Now consider the case with income investors who look to generate part of their return through dividends. It's certainly true that dividends have also been impacted by the GFC, but the decline here was substantially less than was the case with share prices. Moreover, dividends have proven to be extremely consistent over the long term. Whereas share prices tend to bounce all over the place, dividends tend to be significantly less volatile.
As you can see, BHP Billiton's share price has (like all stocks) had a bumpy ride over the years. But its dividends have been remarkably steady, virtually never going backwards even over the recent market difficulty. They could well drop a little in 2010, but I bet they don't experience the kind of declines experienced by the share price.
It's a fair criticism to say that you can justify almost any argument with a selective use of stocks, so let's look at a much wider sample: the ASX200 index. As you can see below, dividend income likewise dropped on average last year. However here we see a decline roughly half that experienced by share prices. Moreover, you can again see how dividend income has been remarkably stable over the years.
In either event, the GFC wasn't kind to investors. But the point is that while growth investors' capital was devastated and may take years to recover, the income investor experienced a temporary pay cut, and a relatively modest one at that. Retirement plans were not destroyed, and investors were able to leave their capital untouched and exposed to any subsequent recovery.
Rising dividends mean rising share prices
Of course capital gains are still important to the income investor. But the fact is that over time, rising dividends translate to higher share prices. Which makes sense; with all else being equal a rational investor should be willing to pay more for an asset that has a higher income potential. And indeed this is what we observe in the market. You will not find a stock that has steadily increased its dividends over time that has not also increased in value, despite the occasional short term perturbation.
There is a subtle yet important distinction to highlight here: rising share prices do not always mean higher dividends, but rising dividends nearly always translate to higher share prices. You can see this in the charts above; the share price tends to fluctuate around the dividend amount, not the other way around.
Of course, dividends are paid from earnings and, assuming payout ratios remain mostly steady, we need to see earnings rise in order for dividends to rise. However if shareholders wish to share in the financial success of the business on an ongoing basis these earnings will be need to be returned, at least in part, to the ultimate owners of the business.
Converting income to growth
Another important point to make is that income investing is equally valid for those who are a long way from retirement. Modern financial wisdom states that young investors should favour growth, and I certainly agree with that, but you can easily turn dividends into shares via reinvestment. This not only means you essentially get paid in extra shares each year, but those new shares will pay a dividend next year, which will buy you more shares, which will pay you more dividends, which will buy you more shares...so on and so forth.Thus the awesome power of compounding is unleashed.
We have already seen that rising dividends mean rising share prices, but when you couple this with an ever growing (indeed exponentially growing) number of shares, you can achieve growth that is truly spectacular over the long term.
This is most elegantly demonstrated by comparing the All Ordinaries index with the All Ordinaries Accumulation index (which reinvests dividends when they are paid).
The scenario under which dividends were not invested saw a total income return of $590,979 and a capital gain of $847,511 giving a total return of $1,438,490 or 1438% on the initial investment of $100,000. And let's face it, that's quite impressive and in itself demonstrates the value of long term investing.
However the reinvestment scenario saw capital grow to a substantial $3,257,693, which is more than double the return we received under the first scenario (126% extra in fact), and represents a total return of 3258% on the initial investment. Put simply, dividend reinvestment and the resulting effects of compounding will give you substantially enhanced growth prospects over the long term.
The other point to make here is that this example covers a period in which we saw a number of significant economic recessions and bear markets. Yet the relentless rise of dividends continued, with scarcely any volatility at all.
Yield isn't everything
By this stage you will hopefully be convinced that income is indeed important, and decide to focus on stocks with high yields. But I would caution you against this. Yield is certainly important, but equally important is the growth in dividends. In many ways it is better to have a stock with a low yield but high dividend growth instead of a stock with a high yield with very low dividend growth (look at the BHP example above).
The total annualised return for an investment can be approximated by the following formula:
Total annualised return = Starting Yield + Earnings Growth Rate (n.b. this assumes that payout ratios are consistent and that dividends are reinvested).
From this we can see that growth is also important for income stocks. But the growth in earnings (and hence dividends) does not need to be as significant as it is for pure growth stocks to achieve the same average total return. For example, a stock with a yield of 4% need only experience growth in earnings of 6% per year to produce equivalent results to a growth stock expecting a growth rate of 10%.
Passive VS Active
I have already worked hard to generate savings and investment capital, and I don't want to have to work for it again. Indeed, I want my capital to work for me! The problem with pursuing a strategy that is focused on capital gains is that it can involve a lot of work. You need to spend a lot of time analysing the market, identifying when prices are high and when they are low, and trying to time your entry and exit into various stocks for various reasons. The responsibility for gains is therefore placed on the investor, not the company, which is in my mind is totally backwards.
Also, because markets are volatile, it means that a growth oriented strategy requires nerves of steel. How well will you be sleeping at night if your shares have just dropped 30% in value in the space of a few weeks? What action will you take? Do you exit out and look to place your capital elsewhere or do you wait in hope for an eventual recovery? It's always a tough decision and involves a lot of angst and soul searching, not to mention a lot of work!
Contrast this with an income strategy which involves sitting back and letting the cash returns just roll on in. The share price can jump all over the place but as long as the dividends remain ok, you don't have a worry in the world. This is the attitude that property investors take and we share market punters can learn a lot from their mindset. How often do property investors value their assets? Not often, if at all, would be my guess. So long as the rental returns remain attractive, they will remain happy with their investment. And rightly so!
Why sell?
The more you think about it, there really are very few reasons to sell a well performing income stock. In fact, the moment you sell you lose access to all future payments.
Yes, you now have access to the capital, but spending that will reduce your overall wealth. Also, don't forget that when you sell you expose yourself to capital gains tax.
So long as you are receiving an attractive, reliable and rising income stream why would you ever consider ending such a beautiful relationship? I can think of only 2 reasons. Firstly, you may need access to your capital for a large purchase, such as buying a house. Secondly, you may have identified another asset with better income characteristics. Other than that, why would you sell?
Growth investors on the other hand MUST sell in order to reap any rewards. Again, they must work hard to reallocate the capital, they will need to pay capital gains tax, and they will be subject to the uncertainty of short term fluctuations.
In a nutshell
A focus on capital gains alone is really putting the cart before the horse. Dividends and their potential for growth are far more important, and besides will ultimately deliver capital gains anyway.
The main points to remember:
- Dividends are on average very dependable and will tend to grow over time
- Dividend returns are less susceptible to market downturns
- Capital gains can only ever be accessed by selling, whereas dividend returns are received like clockwork without having to touch your capital
- Income can be converted to growth via dividend reinvestment. Moreover the growth will be exponential in nature over the long term
- Income returns significantly enhance total return
- An income strategy is low maintenance and requires little effort.
Download HUBB's free scanning & charting software at http://www.hubbinvestor.com/
All recommendations are provided without consideration of any specific reader's investment objectives, financial situation or particular needs. Those acting upon such recommendations do so entirely at their own risk.
