Why past dividends are no guide to the future

With no distinct cost of capital and limited creative destruction, markets have been on edge, focusing on themes such as quality, safety or yield at almost any cost. Visibility of earnings in particular has been trading at a large and increasing premium compared with other parts of the markets.

Many of these themes tend to pay dividends and so investors have flocked to such names. However, the operative words are ‘tend to’. Not all dividends are made equal. Therein lies opportunity and danger.

Despite being regarded as a single homogeneous category, dividend-paying stocks vary just as broadly as the rest of the market and require the same level of scrutiny as other investments. For instance, not all alleged safe stocks provide dividends. and conversely, dividends do not directly correspond with safety, however one defines it.

Relying on a dividend stock’s supposedly safe connotations is no substitute for understanding the business underlying it. Investors should first decide on why they are searching for dividends in the first place.

Investors who need yield to meet set liabilities or living costs are most at risk because they are, by definition, price insensitive. Having presumably been pushed out of government debt into credit and equities, these investors have no choice but to buy high dividend stocks regardless of the underlying risk. 

Although a high dividend yield often betrays poor fundamentals. In the first quarter of 2016, many UK stocks cut or reduced their dividends to the extent that £19bn of assets fell out of the income fund category. Due to the large-scale cutting of dividends, funds were no longer able to produce 110 per cent of the index’s yield as required by the Investment Association’s definition of an income fund.

Dividend coverage and payout ratios, as well as management’s track record of capital allocation, can give investors insights into the likelihood of realising the dividend advertised by the company. A dividend cut is often the right thing for a company in trouble because it releases cashflow to deploy in restructuring, but this is little comfort for an investor requiring yield today.

For investors who enjoy the luxury of a long-term investment horizon in these uncertain times and are more focused on total return, the choice is more varied. This framework tends to promote more rational decisions when looking at dividends.

One approach is to focus on rising yield rather than starting yield. Names with low starting but steadily growing dividends can produce material outperformances on a total return basis when compared with either non-dividend stocks or those with high and unstable dividends.

Re-investing the growing yield will further compound investor returns and produce huge rewards for investors willing to understand the value of stable dividends. Taking the S&P 500 as an imperfect example: the price return of the index since January 1, 2000 is more than 43 per cent, but the total return achieved by reinvesting dividends is just short of 100 per cent.

Throughout the period, the dividend yield doubled from 1.1 per cent to 2.2 per cent. Despite some of the discussed pitfalls, the huge potential benefit of dividends to returns is clear to see. 

Looking at overall yield rather than just dividends can also help investors tailor investment decisions to their needs. The US in particular is a fertile ground for stock buybacks because many corporates there have large cash reserves and few opportunities to spend it on high return projects. 

Different areas tend to use the most efficient method of returning cash to investors depending on the tax system in place. By introducing buybacks into their frameworks, investors give themselves another tool to exploit and more flexibility to avoid the most precarious dividends.

Understanding the underlying stock remains the most important factor in dividend investing. Applying a bottom-up approach will help protect investors from dividend cuts. 

It is unclear what will trigger the unravelling of the crowded trades of recent markets, but the broad uptick in yields across the globe may herald a mass re-pricing of bond proxies if it continues. Prudent investors would do well to limit their exposure to such weakness.

Christopher Meurice is associate director at Signia

Key points

Dividend-paying stocks vary just as broadly as the rest of the market. 

Investors need to understand the industry in which the dividend-paying company is operating.

Understanding the underlying stock remains the most important factor in dividend investing.