M&G Investments: The potential power of income to deliver long-term returns

Equity income was once a popular and well-established investment strategy, offering investors a chance to capture the power of compounded dividend appreciation over the long-term. In recent years, however, it has been somewhat overshadowed by the outperformance of growth stocks largely led by US technology stocks. Capital gains took a precedence during the post-Global Financial Crisis era of ultra-low interest rates and quantitative easing measures implemented by central banks. Now we find ourselves in a very different environment, we believe the forgotten art of dividend investing could be making a comeback.

The Global Financial Crisis (GFC) of 2008/9 has had a profound impact on many areas of the investment landscape, not least income investing. When central banks ushered in an era of ultra-low interest rates and quantitative easing¹, investors seeking yield were forced to look beyond the traditional areas of bonds and cash savings accounts.

This gave rise to the saying ‘There is No Alternative’ – or TINA – the notion that with rates at rock bottom, investors who wanted to achieve a decent return were obliged to invest in stocks.

A forgotten art form

In recent years, equity income – or dividend investing – has also found itself in the wilderness. What was previously a popular and well-established investment strategy has become a somewhat forgotten art form. The sizeable capital gains provided by ‘growth’ stocks (which typically do not provide a significant income) have arguably led to investors overlooking the steady, consistent returns associated with dividends.

The divergence in performance between non-dividend-paying stocks and dividend payers has been stark: Since 2023, the highest dividend-paying stocks have trailed the lowest payers by a considerable distance.

The outperformance of growth stocks goes a long way in explaining why income-focused equity strategies have fallen out of favour. The market has been driven by large US technology companies, which by and large, at least until recently, did not pay major dividends. Investors became accustomed to the significant and relatively rapid capital gains from technology stocks and forgot about the slow and steady nature of income investing.

Dividends in a higher rate environment

Today, however, we find ourselves in a very different environment. The extraordinary period of low interest rates has ended. TINA is no more. Now that interest rates in developed markets have risen to the highest level in 20 years, the landscape for income investing has been transformed. Equity income is now arguably competing on a much more level playing field than it was in the past decade, but could we see investors shift their focus back to dividends once more?

“Now that interest rates in developed markets have risen to the highest level in 20 years, the landscape for income investing has been transformed.”

Of course, high rates presently make cash a much more competitive alternative as a risk-free asset. However, we believe investors ignore dividends at their peril. Dividends not only provide a signal of financial strength and corporate confidence, but they also act as a major driver of long-term equity returns. Over the short term, valuation is a significant determinant of overall stock market returns but on a 10- and 20-year horizon dividends provide a meaningful contribution, in our view. 

In short, dividends matter. Over the past 25 years, almost half of the total return (the combination of capital growth and income) from US equities has been derived from reinvested dividends and their compounding effect. The S&P 500 Index has generated an annualised total return of 7.4% during that timeframe, with 55% from price appreciation and 45% from the reinvestment of income. (Source: Bloomberg, 30 April 2024).

The benefit of a growing income

The appeal of equity income compared to cash, is that dividends can grow, in our view. Investors have embraced cash as yields have increased but these may be fleeting. Cash rates may well decline over the next 12 months, which could prompt income-seeking investors to revert to equity income. In this situation, dividends become even more appealing because they could provide a growing income stream and increased cashflows.

We believe this has two major attractions. First, it can offer protection against inflation. Rising prices eat away at investors’ wealth but investing in companies that provide a growing dividend can mitigate this. Interest rates that look attractive today may not be that compelling in future years. However, identifying companies that have the business model, assets and strategy to grow consistently and deliver rising dividends is potentially more compelling over a long-term horizon than a short-term, higher yield offering.

The power of compounding

This brings us to the second feature of dividend investing: Compounding. Albert Einstein is said to have described compound interest as the eighth wonder of the world. Dividend growth is a strategy with a tailwind: The reinvestment of growing dividends can be a highly effective way of generating wealth over the long-term, in our view. 

Dividend investing may appear steady and relatively unglamorous on the surface, but by harnessing the power of compounding it can potentially accelerate investors’ wealth accumulation and help them reach their long-term financial goals. 

Rediscovering income

The investment landscape has changed dramatically since 2022 with the inflation shock that followed the Covid-19 pandemic and the aggressive rate hiking cycle by central banks. The world is arguably still adapting to this new regime. Significantly, investors are also having to reassess their approach.

We believe there is a reasonable prospect that investors will rediscover the investment ideas and themes that were in favour, and successful, in the past. Capital growth has generated all the attention in recent years, but we think it is important to remember that income represents a significant proportion of the total investment return in many asset classes. We believe dividend growth, in particular, can be a winning strategy due to the aforementioned benefits of compounding.

Dividend-paying stocks have been disregarded for an extended period and we see value in a variety of areas – from the utilities sector to the consumer staples and healthcare sectors. Encouragingly, we also observe a backdrop of strong corporate cashflows which is conducive to continued momentum in dividends.

With plenty of value on offer and the potential for a dividend that grows over time, we believe now is a compelling moment for investors with a long-term horizon to consider equity income and dividend paying strategies once again.

¹Quantitative easing involves central banks purchasing assets, typically government bonds, to increase the money supply and stimulate economic activity.
 

By Johnny Hughes, Head of Global Equity and Multi Asset Investment Specialists

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.