Invesco: Dividends matter: the tortoise and the hare

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Invesco Global Equity Income Fund (UK)

Equity income funds have fallen out of favour over the past 10 years. The low interest rate and low inflation environment that has prevailed over this period largely benefitted funds tilted towards the growthier and riskier parts of the market. Total returns have been dominated by capital growth (coming largely from price-earnings ratio expansion), with contribution from dividends making up a very small portion of total return…a historical anomaly.

We think this will change as more and more investors come to terms with what is a very different investment environment ahead of us – that of higher interest rates, increased inflation volatility and a much more uncertain macroeconomic backdrop.

Reliable income in an unreliable environment

In the current environment of heightened macro uncertainty and ‘higher for longer’ interest rates, we think the value of good operators and capital allocators will become more important. The days of borrowing at near-zero rates to fuel growth are over and capital will need to be allocated much more efficiently.

The beauty of dividends is that they force management to be disciplined. When a company has a history of paying and growing dividends, the market expects this to continue, as it’s the reason most investors will have bought the stock in the first place. Knowing this, management will usually start out the year with a dividend payout in mind and then allocate the remaining budget accordingly.

In addition, there is no creative accounting involved with dividends – they’re paid out in cash from real earnings. Companies that can sustainably return cash to shareholders, while remaining profitable, should be attractive to investors.

The counterargument has always been: why can’t they reinvest the cash into the business to expand and grow faster? We agree that this should be the strategy when there’s genuine opportunity to continue to reinvest and achieve higher growth. Indeed, the flexibility in our approach of thinking about yield at the portfolio level means that we can and do own some of these companies (e.g., Microsoft and Nvidia). However, we also know that these opportunities are not easy to find, especially once an industry has matured.

At this point, management can either burn through cash in search of the next high-growth opportunity (or vanity project) – something we’ve seen time and time again. Or they can return some of it back to shareholders and focus only on the best projects. We know what we’d prefer.

Dividends as a percentage of total returns

Research shows that reinvested dividends have been the primary driver of equity returns over the long term. However, the proportion of total equity return that is provided from the dividend yield of a stock is often overlooked. Figure 1 shows that the impact of dividends has been significant and, importantly, consistent.

Figure 1. 10-year rolling composition of returns for the MSCI World index

Source: Société Générale. Data as of 28th February 2023.

Even though dividends have contributed less to total return over the past decade, this should be seen in the context of record low interest rates and a preference for long duration growth stocks. As we’ve seen over the last 12 months, the environment is changing, and dividends will become a more important part of total shareholder returns.

Figure 2. Annualised MSCI World returns decomposition in %

Source: Société Générale. Data as of 28th February 2023.

Do dividends hedge against inflation?

Equities are often said to offer long-term protection against inflation, and one way they do that is through the dividend income they provide. Some may worry that equity markets are fully valued after a decade of quantitative easing. They may be right, but if you are a long-term investor in a market going sideways, dividends (and active management) can still make a difference.

If you look at the S&P 500 index performance in Figure 3, you can see this has happened between January 1973 and July 1980. The index staggered down from 120 in January 1973 to 62 in October 1974, before gradually clawing its way back up again to 120 in July 1980. 

Figure 3. S&P 500 index performance

Source: Bloomberg as at 10 May 2023. S&P 500 index closing daily values in nominal terms between January 1973 and December 1981. Does not include dividends or factor in inflation. Past performance does not predict future returns.

What happens when you factor inflation into the numbers? Well, the story gets even bleaker. Adjust prices for double-digit inflation in the early part of this period, and it was only in July 1987 that the price of the S&P 500 index recovered to the level seen in January 1973 in real terms.

Yet, the total return of the index with dividends reinvested over those 14 years was 381%, representing a CAGR of 12%. Adjusted for CPI, that’s still 4.2% a year in real terms – a lot better than the index charts alone might imply.

Figure 4. Dividend growth has historically kept up with inflation

Source: Société Générale. Data as of 28th February 2023.

The story of the tortoise and the hare

We want to end with a chart that – in our opinion – illustrates the story of the tortoise and the hare. We’ve already explained why, from a historical perspective, dividend-paying stocks should form the core of any equity portfolio. Figure 5 illustrates this with a more recent example – we’ve gone back to the start of 2020 and compared the cumulative returns between high growth stocks and good quality dividend-paying stocks.

Figure 5. Dividend Aristocrats vs Growth stocks

Source: Société Générale. Data as of 28th February 2023.

This was one of the most pivotal periods in recent history in terms of the impact it had on economies and the market, as well as encompassing two very different monetary policy regimes.

For context, Dividend Aristocrats consist of companies that have raised their dividend for at least 10 years. As you can see, Growth significantly outperformed Dividend Aristocrats in the first half, seemingly leaving no hope for Dividend Aristocrats to catch up.

Ultimately, those lofty growth expectations didn’t quite live up to the hype…

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Important information

All information as at 10 May 2023 unless otherwise stated.

Views and opinions are based on current market conditions and are subject to change. This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication