CPD: The resilience of dividends in volatile markets


If you want to focus on companies that are paying high dividends, you need to pay a lot of attention to whether those dividends are sustainable over time.

With interest rates around the world hovering around historical lows, investor appetite for alternative income sources, particularly dividends, has increased markedly. Although some investors might be fearful of dividends being affected by market volatility, history tells us that dividends are, in fact, remarkably resilient in volatile markets. In this article, Grant Samuel Funds Management looks at the benefits dividends can deliver to investors.

At the end of October 2018, Australian investors had more than $91.2 million[1] idling in term deposits, earning an average 2.00 percent per annum[2], a level that would be lower than the inflation rate on an after tax basis for many investors.

Despite this volume of funds on deposit, investors have also hunted for alternative sources of income. Central bank action across Europe, the US and Australia to keep rates low have flowed on to bond yields and, consequently, equity markets have benefited as investors sought higher returns from capital growth and dividend income. These components of equity returns – growth, earnings and income – are causally linked and income generating equities can provide investors more than just an income stream.

Dividends – an important component of equity returns

When you consider the rationale for investment, it’s to grow wealth, ideally, without having to suffer through any significant losses along the way. Among publicly traded securities, equities have historically been the best way to grow wealth.

There are two ways to make money from equities: through dividends and through price increases. If you think of the price of a stock as its earnings times its price/earnings (P/E) multiple, then you can break down any price changes into the product of the change in earnings times the change in the P/E multiple.

Putting it all together, the money made from owning stocks comes from three things: the dividends, the change in earnings and the change in the P/E multiple.



Figure one shows how the rolling 10-year return for the S&P 500 Index has broken down between those three components going back to the 1930s. You can see that dividends have been a positive contributor in every 10-year time period, and earnings have contributed positively in all but five of the eighty-two rolling 10-year periods.

You may also note that the contribution from dividends seems to have decreased starting in the early 1990s. That is due to the fact that regulatory changes ten years earlier made share buybacks an attractive (and tax-efficient) alternative to cash dividends, and companies began to make increasing use of this additional method for returning cash to shareholders.

Because buybacks reduce the outstanding share count, they tend to drive up earnings per share, so some of what used to show up in this analysis as the contribution of dividends has been transferred to the earnings contribution.

It is worth noting that it’s exceptionally rare for one component to be the dominant driver of returns and even more rare for that component to be valuations. According to Epoch Investment Partners (Epoch), in the history of the market, going back to 1926, valuations have accounted for only 8.4% of returns, while earnings and dividends accounted for 50.4% and 40.7% respectively. With valuations no longer supported by QE-driven interest rates, earnings and dividends will likely return to their positions as the main drivers of return.

It is the change in the P/E multiple in Figure one that has constituted the biggest “swing factor” between when stocks have done particularly well (as they did in the 1980s and 1990s) and when they have done particularly poorly (as they did in the 1970s). Over the long term, these swings in P/E ratios have almost completely netted out, and the contribution of P/E changes to the cumulative return for the S&P 500 over 80 years has been less than 1% per year. Dividends and earnings have driven the vast majority of the return on stocks.

A history of dividends

As illustrated in figure two, dividends play an important role in low growth periods, such as 1930-1949 (the Great Depression and Second World War) and the 2000s. Dividends were comparably modest contributors to returns during the 1980s, 1990s and the decade following the Global Financial Crisis (GFC) when equities delivered high price earnings growth that dividends paled into insignificance.



Dividends and volatility

The saying “profits are a matter of opinion, but dividends are a matter of fact” encapsulate the reason that dividend paying companies tend to hold up well during volatile times. Profits are calculations based on a range of real and estimated data and have been known to be overstated; dividends are tangible, paid from corporate earnings.

As such, dividend paying stocks generally provide investors with tangible returns on a regular basis, irrespective of market conditions. As well as being a sign of good corporate health, as illustrated in figure two, dividends can help to mitigate losses when a company’s share price falls.



Apart from the obvious income benefit, in the long term, stocks that pay a consistent dividend tend to outperform those that either cut or cancel announced dividends or don’t pay any at all, as illustrated in figure three. In fact, from May 1994 to June 2018, companies in the MSCI World Index that paid stable dividends returned 6.8% on an annualised basis; those that consistently grew their dividends over this period did better, returning 10.1% per annum.

Companies that did not pay a dividend had a considerably lower annualised return of 6.7%, and those that cut their dividends delivered nearly half of the return provided by the dividend growers, at 5.4%.

Importantly, the consistent dividend payers achieved better returns with lower volatility. Dividend growers had a standard deviation of 14.2% per annum, and those with stable dividends experienced 15.2% per annum. The dividend cutters (19.9% p.a.) and those companies that did not pay a dividend at all (18.3% p.a.) delivered their lower returns with greater volatility.

Epoch’s focus on companies paying out high levels of dividends has delivered an ‘unintended consequence’; the stocks Epoch own tend to experience less volatility than the market. Because the total return that these companies generate over time is more ‘front loaded’ than that of the average company, there is less uncertainty around it, and the price movements over time reflect that lower uncertainty.

Why is low volatility in a share portfolio a good thing?

Low volatility can mean greater wealth for investors over time. This comes down to the power of compounding. As every investor soon learns, if you earn 50% one year but lose 40% the next year, your ‘average’ annual return may be positive (the average of +50 and -40 is +5), but you have 10% less money than you started with. The dollar you started with grew 50% to $1.50 at the end of the first year, but a drop of 40% from that level means a loss of 60 cents, leaving you with only 90 cents.

Meanwhile, an investor who earned 20% in the first year and lost 10% in the second year will have the same average annual return – i.e., 5% – but will have $1.08 compared to 90 cents; that invested dollar first grew to $1.20, and then fell 10%, or 12 cents, to $1.08.

The lesson is that if a portfolio can generate the same average annual return as the market, but does so with less volatility, the investor ends up with a higher annualised return than the market – i.e., the investor will have more money than if they simply matched the index return each year. Low volatility is more than just a theoretical talking point; it’s a very tangible benefit.

The future of dividend growth

Epoch believes the outlook for earnings growth is relatively modest. Ultimately, earnings growth derives from, and in the long run approximates, nominal GDP growth.

This is not necessarily bad news for dividend growth. We live in a time when technology is helping companies to improve their return on equity, through a combination of higher profit margins (as technology is substituted for labour), greater asset utilisation (as technology enables firms to generate more sales per dollar of assets), and higher leverage (as technology simultaneously allows firms to operate with fewer assets, which means they can return excess capital). All of these forces point toward companies being able to operate with less capital than was necessary in the past, meaning that firms will be able to return more of their cash flow to their shareholders—i.e., payout ratios should rise.



In a world of low nominal GDP growth combined with a trend toward “capital light” business models that enable companies to pay out more of their cash flow to the owners of the business, Epoch believes that dividends will be the dominant driver of shareholder returns. And that is why Epoch’s Global Equity Shareholder Yield strategy focuses on companies that have the ability to generate consistently high levels of dividends to shareholders, whether they take the form of cash dividends or share buybacks.

The key word in that last sentence is “consistently.” Identifying the companies with the highest dividend yields is easy. Figuring out which ones will be able to sustain their dividends is another matter. A high dividend yield can sometimes be a sign of a company in distress. When a stock’s price falls, its yield rises, assuming the dividend hasn’t changed.


Identifying the companies with the highest dividend yields is easy. Figuring out which ones are able to sustain their dividends is another matter.


So when a company encounters some sort of downturn, and its stock price falls, its yield will rise. But often the developments that led to the drop in the stock price will eventually force the company to cut its dividend, with a lag. After the stock prices of many major banks fell sharply in the fall of 2008, their dividend yields—based on their trailing 12 month dividends at that time – were extremely high.

But of course, those dividends were unsustainable in the aftermath of the financial crisis, and most banks were forced to slash or even eliminate their dividends as time went on. Similarly, many energy stocks appeared to sport very high dividend yields in late 2014, because the sharp drop in the price of oil had driven their stock prices lower. But they, too, were forced to eventually cut their dividends, because the low price of oil meant they did not have the operating cash flow to sustain the previous level of those dividends.

Therefore, if you want to focus on companies that are paying high dividends, you need to pay a lot of attention to whether those dividends are sustainable, and on whether they can be increased over time. A share portfolio comprised of companies paying a sustainable and growing dividend will be better positioned to ride out challenges in the years ahead.

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[1] APRA monthly banking statistics, October 2018
[2] RBA deposit rates, October 2018
Important information: The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2018 Grant Samuel Funds Management.

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