The importance of dividends

It's difficult to overstate the long-term value of a strong and rising level of income to a portfolio. There's no shortage of research to demonstrate just how greatly long-run returns are influenced by the reinvestment of dividends. And, the longer the investment horizon, the more important dividend income becomes. This is because the reinvestment of what may initially appear modest dividend amounts can soon grow to become a dominant part of the total return.

Those stocks that are able to offer a consistent and rising level of dividend have tended to strongly outperform during such periods partly as a result of investor demand. This has historically seen funds which invest for equity income outperforming those which invest purely for growth during periods of declining market sentiment.

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 Citigroup¹ 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%.

Because of what it says about a company's health, the bottom line is that most company boards are extremely reluctant to cut dividends, even in challenging times. In the UK, which for many years was by far the most generous market in terms of dividend payments, companies have shown a preference to continue paying their dividends in such conditions by raising their pay-out ratios. Once earnings start to rise again, their 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, as stocks with the greatest earnings uncertainties and the most stretched balance sheets also have the greatest risk of cutting their dividends. This means that to successfully invest in high yielding equities requires detailed research and careful stock selection.

But whereas investing for dividend income was once the sole preserve of UK portfolio investors, a number of fundamental changes to the investment landscape in recent years has made investing for equity income a truly global enterprise.

The emergence of rising dividend levels in stock markets around the world has resulted from the efforts made by many overseas markets to attract a wider investment audience as well as their growing recognition of the need to deliver true shareholder value. Committing to pay and grow dividends is also a sign of the increasing maturity of many overseas stocks because as companies move through the business cycle they tend to require less investment into expansion, research and development and have larger, more regular profits to share with their shareholders. Paying a decent dividend also helps to improve the capital structure of many companies making them thornier take-over targets while improving the stability of their long-term share price.

Investors have also had a part to play. For one thing, they're more dividend hungry after suffering in the bear markets seen at the start of the decade and again more recently. Other factors such as the increasingly ageing populations of the West, which desperately need income-generating assets to support them in retirement, and the relatively unattractive levels of yield on offer from other asset classes, have also added great impetus to this change.

This phenomenon has been especially notable in Asian and other emerging markets where there is a growing realisation that paying high, rising dividends is essential to attracting long-term overseas investment. A similar sea change has also been seen in European markets. The corollary of this is that somewhere around 90% of the highest yielding shares in the world are now found in overseas markets². This means that it is now possible to invest internationally for income and so diversify equity income portfolios away from being so reliant on the UK.

Newton was one of the first senior UK fund managers to spot this emerging paradigm and, by employing the expertise it garnered from managing the industry flagship Newton Higher Income Fund, now into its 23rd year, it launched a series of funds which set about capturing the high levels of dividend income now on offer in overseas markets.

With well over £2 billion invested in high yielding UK equities in the form of the Newton Higher Income Fund³, the arrival of the Newton Global Higher Income and Newton Asian Income Funds in November of 2005, and the subsequent launch of the Newton European Higher Income Fund in January of 2007, have contributed to what is today one of the largest ranges of dedicated equity income funds available in the UK.

But while these funds offer UK equity income investors the opportunity to diversify their holdings across a range of different international markets while maintaining a similar level of yield to that offered in the UK, they also offer another strong attraction at this point in the investment cycle.

The strength of equity income strategies during periods of declining market sentiment means that funds such as Newton Higher Income, Newton Global Higher Income, Newton European Higher Income and Newton Asian Income can all offer investors the opportunity to adopt a more defensive investment approach to achieving longer-term growth.

¹ Source: Citigroup 02 October 2008

² Source: FACTSET

³ Source: Newton. Fund size £2.75bn as at 30 September 2010