The case for Newton Higher Income

There's no shortage of research to demonstrate just how greatly long-run returns are influenced by the reinvestment of dividends¹. This is because the reinvestment of what may initially appear as modest amounts of dividend can become a dominant part of total returns over time. As the chart below clearly shows, the importance of income as part of a total return has been most evident during periods when capital returns turn negative.

A healthy and growing dividend not only contributes to total returns over time, but it also provides a vital clue as to the growth prospects of a company, its cash flow generation and the strength of its balance sheet.

Research by Citigroup² shows a strong correlation between the performance of share prices and dividend changes during the last five market downturns in the UK. According to the findings, stocks that provided above average dividend growth tended to outperform those with below average dividend growth.

The study also highlighted how in previous cyclical downturns, dividend growth has proved far more resilient than earnings growth. During the last five UK economic downturns, dividend growth averaged 3% a year, while earnings fell almost 20%.

The bottom line is that most UK boards are reluctant to cut dividends, even in challenging times, as it would signal serious problems with their cash flow and balance sheet. As earnings fall, UK companies have tended to prefer to continue paying their dividends by raising their pay-out ratios. Once earnings start to rise again, boards start rebuilding dividend cover by reducing their pay-out ratio to their target cross-cycle level.

This fact can be something of a double-edged sword which means that successful equity income investment needs to be done carefully and selectively.

Against an average dividend growth of 3% across the last five down cycles in the UK, current estimates expect dividend growth in the UK market over the next 12 months to be below inflation as more companies, deprived of capital, cut their dividends.

Stocks with the greatest earnings uncertainties combined with stretched balance sheets also have the greatest risk of cutting their dividends. Our analysis shows that banks and consumer-exposed house builders, pubs and some retailers are most at risk.

The next three to five years should see UK equities generate an annual return of around 6%. This is based on a dividend yield of 3.3%³, 0.5% real dividend growth (20-year average excluding inflation) and the Bank of England's inflation target of 2%.

Source: Reuters, CS/LBS Global investment returns yearbook 2009, Reuters/Newton as at 30 June 2010

Past performance is not a guide to future performance. Source: Newton/ Lipper as at 30 June 2010. Income earned on initial investment of £1,000, net of annual charges and UK tax, no initial charge. Financial year ends 15 March 94, 95 and 96, 28 Feb 97, 98, 99, 30 June from 2000 onwards.

The Fund continues to achieve a consistent first decile ranking for income distribution over one, three, five and 10 years in the IMA UK Equity Income sector

Source: Lipper as at 30 September 2010
Income earned on initial investment of £1,000; net of UK tax and annual charges, but excluding initial charge.

Source: Lipper as at 30 September 2010
Fund performance calculated as total return including income net of UK tax and annual charges, but excluding initial charge. All figures are in GBP terms. The impact of the initial charge which may be up to 4%, can be material on the performance of your investment. Performance figures including the initial charge are available upon request.

¹Dimson, Marsh and Staunton (ABN Amro) and Triumph of the Optimists, Princeton University Press, 2002. Global Investment Returns Yearbook 2008

²Source: Citigroup 02 October 2008

³Source: Datastream. It should be noted that a steady and rising income received from an investment is what really matters with the opportunity to grow capital over the long term. Therefore, steadily growing dividend payouts, rather than the historic yield, may serve as a better indicator of the actual health of the underlying investment. When considering the net current yields or historic yields on a fund it is important to understand how they are calculated. They are calculated on the basis of dividing the last 12 months' dividends by the current share price. Due to the calculation method, at times yields may be high and rising as a result of a falling share price, i.e. capital depreciation on your assets, and not a rising dividend. Please remember that dividend income is not guaranteed and may fall as well as rise due to stock and currency movements.