Dividends

Investing for the long term in dividend-paying companies makes a lot of sense. Many empirical studies show that in the long term, buying high dividend stocks is one of the best ways to combine attractive returns with less volatility. Despite this evidence, dividend stocks are often overlooked as investors prefer to buy high-growth stocks whose price appreciation potential is perceived to be more important.

One of the most exhaustive studies on the contribution of dividends was written by Robert D. Arnott, the founder of Research Affiliates. In an article published in 2003 in the Financial Analysts Journal, he analyses the sources of return from US stocks over a period of 200 years, from 1802 to 2002. He shows that over this period, US stocks generated an annualised return of 7.9%, of which 5% came from dividends, 1.4% from inflation, 0.6% from rising valuation levels and 0.8% from the real growth in dividends.(1)

The good results in terms of risk / return produced by a dividend strategy are hardly surprising. On the qualitative side, a high dividend helps to determine the quality of a company’s results and its financial health. On the quantitative side, the dividend provides some 'yield support' for the stock and, when reinvested in bear markets, helps to reduce the time needed to make up capital losses. As well as this, high dividend stocks tend to be attractively valued in relation to their earnings or book value.

The advantages of dividend stocks can only be appreciated over reasonably long investment horizons exceeding a number of years. Moreover, empirical studies also show that the best returns are generated by strategies combining high dividends and a low POR (pay-out ratio - the share of profits distributed in the form of dividends). This seems logical as a too-high POR undermines the sustainability of the dividend.

During the bull markets of the 1980s and 1990s, dividends lost much of their importance – especially in the United States, where they were heavily taxed. The outcome of this is that investors tend to associate the return on a stock with the growth in the stock price forgetting about the dividend component. As well as this, against a backdrop of increasingly short investment horizons and investors looking for the next Google or Apple, dividend strategies do not seem very exciting (neither Google nor Apple currently pay out dividends).

Demographic trends and the ageing of the population could nevertheless result in a change in investor attitudes. Investors will increasingly seek regular income and consequently a larger share of the return on stocks in the form of dividends rather than capital gains (especially since, based on current valuations, it seems illusory to think that the US and European stock markets can produce much more than 4% in real terms annually in the coming years). One could even make the point that given the decline in the 'risk-free’ reputation of government bonds, stocks from quality companies with low levels of debt and paying reasonable dividends could take over from bonds as the default investments in defensive portfolios despite their higher volatility.

Finally, in an environment in which many investors fear the return of inflation, it is important to point out that, unlike a coupon on a bond which is usually fixed, a company can increase its dividend. Dividend stocks therefore offer some protection against inflation.

Our conviction about the long-term validity of a dividend strategy was the impetus behind the launch of our dividend fund, BL-Equities Dividend, just over three years ago. The chart below shows the fund’s performance since launch (November 2007) and its comparative performance against the MSCI All Countries Index (in euro) and the same index with dividends reinvested. The chart confirms the comments above:

• As far as the MSCI index is concerned, the reinvestment of dividends lowers the loss of an investment in this index from 12.3% to 6%;
• The fund outperforms the index as it falls less in bear markets;
• Despite one of the most important bear markets in stock market history, an investor buying the fund at launch would today be on a winning streak.

(1) Source: Robert D. Arnott: Dividends and the Three Dwarfs, Editor’s Corner, Financial Analysts Journal, 2003.

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