The Importance of Dividends

If you’ve followed this blog for a few years, you’ll remember the early articles I wrote about investing for income and an introduction to dividends and today I want to continue that theme with another article about the importance of dividends. I was recently discussing this topic with a friend who told me that they mostly ignore dividend yield on a company and instead focus on the fundamentals, by which they mean the amount of profit the company generates and its Return on Capital Employed.

Although we agree quite firmly about the importance of buying quality companies, my opinion and experience cause me to disagree with him over the importance of dividends. In my own portfolio, I seek a blended yield of 5%, not always achieving it, but coming close most years. This has provided a comfortable float for portfolio returns – some years, capital performance has been weak, but up to a 5% drawdown is pretty much cancelled out by the returns from the dividends. This, of course, presumes that I reinvest the dividends, which thus far I have been content to do.

The benefit of this is that even when individual share prices are moving against me, I am provided with a ‘mental buffer’ in that my overall portfolio value doesn’t look to have been impacted as much as it would have done if I were holding a declining share that paid no dividend. Mentally, this makes it easier to ignore small fluctuations in the price and resist the urge to ‘do stuff’, running up needless trading costs and causing me sleepless nights as I double guess every last swing in the portfolio. In addition, when the share price recovers, I have the added benefit of the dividend in the account, as well as the improved capital value. This quite quite possibly the biggest benefit when I talk about the importance of dividends.

Dividends also provide me with what I like to think of as a ‘ghost annuity’ – income that could be used if my regular income were to be impacted, perhaps from a recession or sudden illness. In effect, it acts as a personal insurance plan, where rather than paying a monthly premium to an insurance provider, saving money today helps to create cover for the future.

Personally, I highly sceptical of insurers and annuity providers; at the end of the day, they exist to make a profit for shareholders – much like credit card providers. In many instances, this profit is warranted; but in other cases, I feel I can create a more personally beneficial ‘policy’ through investing.

Annuities

Let us take a theoretical pensioner at the age of 70. They have worked for around 50 years, saving into a workplace pension every month, but occasionally losing their job, falling ill, or taking time out for other reasons. At these times, the pension contributions were halted, meaning that they only have around 40 years of contributions.

Now for some quick maths. Let us assume that they had an average salary of £50,000 and saved 3% of their salary before taxes (£1,500), giving them a personal pension of £60,000. Now, let us say that their employer contributed 5% of their salary (£2,500), providing another £100,000 for a total pot of £160,000. Now, let us say that the pot grew at an average of 4% per annum, which over 40 years would give them about £388,000 in the final accounting. Of course, this figure will vary wildly depending on the precise years of returns (hint: real-life returns are never going to be a flat 4% for 40 years!).

Now, this pensioner takes their £388,000 to an annuity provider – someone like the Prudential – and is told that if they hand over the entire pot, they will receive an annuity paying out £22,000 per year with no link to inflation. If they want to protect against costs rising through inflation, that figure falls to £14,350 per year, and if they also want their spouse to continue to receive payments after they die, it falls even further to £13,130 per year. To receive their initial pot ‘back’, they would have to draw their income for between 18 and 30 years, depending on the terms of the annuity.

Again, depending on the precise terms of the annuity, this works out at an effective yield of between 3.35% and 5.8% – not too bad you might say, but how many 70-year-olds do you know that are still working? Most people I know retire somewhere between their late 50s and 60s, which again, forces down the expected income from the annuity, depressing the yield to as little as 1.7% for an inflation-linked payout from the age of 55. On this income, the pension would likely never recover their initial capital, having to receive an income for a whopping 61 years, making them around 111 when they eventually recovered their capital.

On a purely financial level, it seems clear to me that if I were in that position, I would be better withdrawing the capital and investing it myself – even if I halved my current yield from 4% to 2%, I’d still be getting more income from my capital, as well as being able to pass the portfolio on to my wife or children when I died. The maths here broadly reflects over to insurance policies as well – for a young worker to take on an income protection policy costs relatively little; to cover 65% of a pre-tax income of £50,000 might cost £100 a month, perhaps even less depending on their health.

The problem arises when you consider the terms under which the policy pays out – you have to be out of work (which you’ll do everything to avoid and is highly unlikely) and even then, the policy only pays out a percentage of lost income. You might receive £2000 a month – but over the course of your life, you might only claim for a year or two, despite paying in your entire career.

The Importance of Dividends

To come back to the original topic of this blog, the importance of dividends, the dividends received from my portfolio act as an indicator of ‘policy health’ – how much of my post-tax income is covered by the dividend income. By reinvesting, rather than spending these, the ‘policy’ becomes more and more valuable over time – each batch of dividends are reinvested, buying more shares, which pay out more dividends, and over time reducing the deficit of dividends to income.

In essence, these dividends are a reward for selecting good companies – a profitable company has four choices; to reinvest in the company, retain profit as cash, to buy back shares, or to pay out dividends to shareholders. Most dividend-paying companies make between two and four payments each year to shareholders based on their profits and expected future performance. Companies usually announce the amount of the dividend and an ‘ex-dividend date’ in their results updates along with useful information about trading conditions, competition, and performance. The ‘ex-dividend date’ is simply the date on or after which a purchasing shareholder will not be entitled to the latest dividend payment.

The investor I was speaking to was of the opinion that the best possible use of profit is to reinvest in the company – employing more staff, developing new products, undertaking research and development and growing and enhancing the business for the future. As a businessman, I absolutely agree; this IS the best possible use of the capital – but assuming that all investments the company could make are equally valuable is unwise. For example, let us say that a company with a payroll of £10m makes a £10m profit and decides to double the salaries of all its employees (unlikely, but bear with me). Are those employees now going to be exactly twice as productive and generate twice as much profit for the company?

Although this is a bit of a strawman argument, I believe the principle itself stands up. From the shareholder\’s point of view, the company’s cost base has now increased but with a smaller increase in profit – as such, earnings per share would decrease, reducing the value of the company. Compare this to paying out the £10m in dividends – although the company’s value would also decrease by £10m (reflecting the reduced cash balance), the shareholders would have received this cash, in effect keeping them at a ‘level’ value. The company would also have the ability to organically grow its profits over time – perhaps using a percentage of this the reward employees – but also returning capital to the shareholders.

As such, I have always favoured dividend-paying companies over those that pay no dividend. If correctly managed, these are a small reward to shareholders for their investment and reflect the profitability and strength of the company. These are just a few of the reasons I talk about the importance of dividends and actively seek out dividend-paying companies for my portfolio.

Finding Dividend-Paying Companies

There are two things I look for when selecting dividend-paying companies; the first is to select companies with a higher than average yield (by which I mean the average of the market the company trades in – for the FTSE, this is usually around 2-3%). The second is to select companies with good dividend cover – anything above 1 means that the company is generating more in profit than it is paying out in dividends, but generally, I prefer companies with over 1.5x dividend cover. Anything much less than this and the company needs to grow its profits quicker than the dividend or risk being forced to start cannibalising itself to pay the dividend by using cash reserves or taking on debt. Alternatively, the company could cut or even cancel the dividend – not a great thing for an income seeker like me!

Finding Quality Dividend-Paying Companies

If a company passes both of these criteria, the likelihood is that it will then pass my next criteria; being able to increase the dividend. This is the real sweet spot for income seekers and a key part of the importance of dividends. As we all know, prices of everyday items such as groceries, phone bills and clothing only go one way – up. As such, we all need to grow our income by at least the same rate or face being gradually priced out of doing and buying more and more things over time.

A high-quality dividend-paying company helps to counteract this by increasing its dividend over time. For example, in 2017, I bought a company called Warehouse REIT during IPO at £1 a share. The company paid out 0.9p a share in 2018, 4.78p in 2019, and 4.94p in 2020. The share price has increased to £1.19 since then and has dividend cover of over 1.7x.

This is exactly the sort of company I like to buy and hold; I can ignore the day-to-day price fluctuations and take a healthy and growing dividend from the company over time. The company does, however, also have to be a ‘quality’ company, in that it should be profitable, have low debt and a high return on capital.

Providing the company has these characteristics, it is likely to be a quality dividend-paying company and once which I am likely to add to my portfolio.

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