It pays dividends to manage shares astutely
Wobbles about what the US Federal Reserve said, concerns about Chinese monetary policy and a sense among many that equity markets had rallied too fast brought a sharp and nervy sell-off. It, once again, underlines the key importance of dividends when managing your shares.
Over the last 50 years the divided yield in the market is nothing spectacular, at around 3% presently, so you’d probably think it is a useful income-source but not as exciting as capital growth. Company newsflow, including regular results or transactions tend to dominate the way equities are presented in public.
It may come as a surprise then to discover that over the last 50 years no less than 80% of total returns on the S+P 500 Index have derived from dividends. Steady regular dividend payments that grow in line with the progress of solid companies struggle to grab the headlines on 24/7 financial TV shows.
Yet, the power of compounding, linked with the tangible income that derives from dividend flows helps investors to build real value in to their nest-eggs.
Typically, you will read about dividends in the last line of a media report on a set of company results. After detailed copy on the company’s performance and its strategy there may be a cursory comment like “a dividend of X cents has been declared, up 5%”. For many this can be a bit of a yawn but for me its one of the most telling disclosures.
If you are serious about constructing a portfolio of equities it is crucial to take a long-term perspective. Building a foundation of strong dividend-paying companies sets up a stream of income that, hopefully, can grow as your (don’t forget your shares give you part ownership of these business, no matter how small the holding) company sets forth to perform. The task of creating a portfolio of this type is harder than you might imagine.
First, how well covered is the dividend by annual profits? A tight coverage ratio (for example close to 1x) carries the risk that in a poor trading period the company struggles to pay dividends without dipping into reserves or borrowings. One risk in that scenario is a dividend cut, which is never good news for long-term equity holders.
Second, what type of capital structure exists within the business? If debt levels are low then the risk of a missed dividend is lessened if leverage is high. Then, management could at some point choose to forego dividends in order to preserve the integrity of the business.
Of course the stock market offers investors a huge array of business models that operate in a wide group of sectors. It also gives investors access to very different levels of scale, ranging from start-ups to huge global transnationals.
Within this broad spectrum many companies offer investors a zero dividend policy but instead propose a capital growth model that aims to convert expansion and financial success into higher stockmarket ratings and associated rising share prices.
These too can provide investors with attractive returns but are, by definition, further up the risk curve than companies that may be slower to grow, but generate consistent dividend flows.
Tax stands as a material consideration when managing your assets. A pension fund that ensures income is tax free allows an investors to grow a long-term asset unfettered until drawdowns commence upon retirement.
Exposure to income tax, in contrast, takes up to 50% of dividend income away which has a direct effect on the net gains deliverable from an investment portfolio. Capital gains tax is lower (33% currently) but has been rising as the Exchequer seeks ways to derive more resources from us all.
As in life, investing can be optimised by a sense of balance. I’m a bit of an Evangelist around dividends but can see too how a capital gains focus adds spice to a portfolio. However, like puppies, dividends are for life and not just for short-term excitement. Treasure them when investing.
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