With declining bank term deposit rates, there has been increasing interest in dividend yields as a source of income for investors.
But how do you determine how sustainable dividend yields are?
“It is a straightforward process to screen for high-yielding stocks and build a portfolio around them,” says Tom Stevenson, Investment Director at Fidelity Worldwide Investment.
“However, this simple quantitative approach fails to recognise that the high yields available on certain shares can be the result of deteriorating fundamentals and collapsing share prices. It also fails to give any consideration to the fact that some high-yielding companies could subsequently cut their dividend. A high yield does not always imply value.
“The only way to determine whether there is value in a high yielding share is via fundamental research,” says Mr Stevenson.
“It’s a matter of historical fact that dividends and dividend growth are the key drivers of total return over time. Companies that have a track record of consistently growing their dividends tend to be rewarded with higher share prices. Long-term investigations of investment returns bear this out. They also support the idea that dividend payouts provide a valuable, positive signal for future earnings growth. Finance directors typically pay out larger shares of earnings when they are optimistic that the dividend can be sustained. Moreover, high payout ratios are typically consistent with more carefully chosen capital spending projects that are also supportive of the share price.”
Mr Stevenson says “we believe that the dividend policies of companies contain predictive power which can be revealed via thorough fundamental analysis. While earnings can be manipulated by a variety of sophisticated accounting treatments, dividends cannot. In this way, they provide an accurate picture of a company’s financial health.
“Moreover, companies that can grow their dividend consistently are invariably healthy businesses with stable earnings growth and high free-cash flows; all factors that are rewarded by the stock market in the fullness of time. The link is clear: a company’s dividend policy can be a key indicator of earnings growth, which is in turn a key indicator of share price performance.”
He adds “owing to their generally defensive qualities, it’s not surprising that dividend-paying stocks tend to outperform in bear markets (as they did in 2011). What is surprising is the evidence that suggests that over the long run, this is also true in bull markets.
“In the past 10 bull markets, US dividend-paying stocks outperformed their non-dividend paying counterparts by over 3% a year, on average. The implication of this is that over the long-run, across all market cycles, dividend-payers tend to be better performers than non-dividend payers.
“One plausible explanation for the general outperformance of dividend-payers is that they are less likely to be overvalued than non-dividend payers, which are often ‘growth’ stocks that are more prone to excessive levels of investor optimism. Conversely, high dividend-paying stocks often fall into the ‘value’ or unloved stock category, which may be susceptible to excessive or unwarranted investor pessimism.”
Source: Ned Davis Research. Bull and bear markets as defined by Ned Davis Research. Based on equal-weighted geometric average of total returns (including dividends) of dividend paying and non-dividend-paying historical S&P 500 stocks. Bull markets from 1/31/72-12/31/10, as defined by Ned Davis Research, are: 1/31/72-1/11/73; 12/6/74-9/21/76; 2/28/78-9/8/78; 4/21/80-4/27/81; 8/12/82-11/29/83; 7/24/84-8/25/87; 10/19/87-7/16/90; 10/11/90-7/17/98; 8/31/98-1/14/00; 9/21/01-3/19/02; 10/9/02-10/9/07; and 3/9/09-12/31/10. Bear markets from 1/31/72-12/31/10, as defined by Ned Davis Research, are: 1/11/73-12/6/74; 9/21/76-2/28/78; 9/8/78-4/21/80; 4/27/81-8/12/82; 11/29/83-7/24/84; 8/25/87-10/19/87; 7/16/90-10/11/90; 7/17/98-8/31/98; 1/14/00-9/21/01; 3/19/02-10/9/02; and 10/9/07-3/9/09.
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