The stock market is an uncertain place, and for many investors the constant ups and downs can be a source of stress and anxiety. Yet there may be a solution: investing with dividends.
What are dividends and how do they work?
Dividends are the distribution of profits a company makes to its shareholders. If you own shares in a company that declares a dividend, you receive a slice of that money, and they can play a crucial role in long-term stock market returns.
While stock prices can fluctuate, sometimes wildly, in the short term, dividends provide a steady stream of income that can help to offset these movements. Although they are often overlooked, the reinvestment of dividends is a powerful force, compounding returns to produce substantial growth over time. Even if a share or the stock market doesn’t appreciate much, or even falls, the effect can mean your money still grows.
As the chart below illustrates, an investment mirroring the US S&P 500 index has turned £1,000 into £6,361 in capital growth terms for UK investors over the past 20 years, but with income reinvested that rises to £8,384. For the higher yielding FTSE 100 in the UK, dividends have been even more vital. They are not the icing on the cake, they are the cake. A £1,000 investment has turned into only £2,179 in capital growth terms, but with reinvested dividends it is £4,577.
Chart: Illustrative returns from a 20 year investment in the US and UK stock markets
Source: FE Analytics, data to 31/01/2023 past performance is not a reliable guide to future returns; index returns without any effect of fund charges applied.
Why do companies pay dividends?
The decision of a company to pay dividends is generally based on its financial situation and strategy. Some companies choose to do so to reward shareholders for their investment and to signal to the market that they are financially stable. Other companies choose not to pay dividends because they prefer to use their profits to invest in growth or to pay down debt.
Companies in more stable industries, such as utilities and consumer staples, are more likely to pay dividends than companies in faster-changing industries, such as technology and biotechnology. This is because companies in stable industries typically have more predictable cash flows and are less likely to experience large fluctuations in revenue or profits. As a result, they are better able to make consistent dividend payments to shareholders.
On the other hand, smaller or emerging companies may be more focused on growth and may prefer to reinvest their profits in order to achieve higher returns in the long term. Other companies may not have the financial resilience to make consistent dividend payments, or they may choose to focus on other forms of return, such as share buybacks, or debt reduction.
Are dividend stocks less volatile?
Occasionally, I’m asked: ‘are dividend stocks are less volatile than other investments?’ My answer is, not necessarily. But a steady return from dividends can help generate long-term returns and bolster portfolios in periods of market stress. Higher dividend shares often have a valuation ‘safety net’ of the income stream they provide, so they can be less risky. This is because dividend payers are typically more established and more likely to generate consistent profits. Knowing that dividends are likely to continue rolling in can be reassuring for investors, especially in times of market uncertainty.
Remaining invested at all times can help harness the best returns from dividend paying stocks. Investors still get ‘paid’ during more difficult market periods when capital gains are harder to achieve. Holding these stocks for long periods takes advantage of the long-term compounding of income, as well as the growth potential.
As well as being important for investors who are looking to build long-term wealth over time, dividends can help to provide a stable source of income that can be used to fund income needs in retirement or other financial goals.
Risks of dividend investing
Investing in the stock market always comes with the risk of your investing falling in value, and when targeting dividend-paying shares investors need to be aware of potential ‘value traps’. Sometimes a dividend yield looks high, but it isn’t always sustainable. In fact a very high yield could be a sign of distress. In these cases, if the dividend is cut or cancelled then the shares could fall in value, possibly substantially. This is why investors should not solely focus on the highest dividend paying stocks or funds. Securing a lower, growing income tends to be more important in the long run than achieving the highest starting yield.
Looking at the current economic environment, dividends in certain sectors could come under pressure from higher interest on debt, rising costs or a weaker consumer. Every company and sector has its vulnerabilities, so it’s a good idea to have a broad range in your portfolio. Company earnings, and therefore dividends, fall as well as rise, but over time as economies and industries expand there should be an upward trend in dividends, hopefully providing a reasonable hedge against inflation when you zoom out to the long term.
Harnessing dividends in your investing strategy
Investors can build their own portfolios of dividend-paying stocks, but funds offer a convenient way to achieve diversification across dozens of companies’ shares in one go. Those with strategies targeting dividend-paying stocks tend to be found in either the Global Equity Income sector for international shares or the UK Equity Income sector for UK shares. Other, more geographically specialist, dividend-based funds can be found in their respective broad geographic sectors such as Europe ex-UK and Asia ex-Japan.
If income isn’t required, an investor can elect to buy accumulation units in a fund, rather than income units which pay the income out. Accumulation units in equity income funds reinvest dividends for you to turn income into growth and allow you to automatically compound dividend returns, and they can help form a more stable core to a portfolio compared to more growth-oriented or specialist funds.
With equity income funds typically offering yields in the region of 4-5% currently, and with the potential for the income to grow and compound over time, they could be an appealing option for investors, though remember all yields are variable and not guaranteed.
Dividend funds to consider
Here are some fund ideas our Collectives Research Team believe offer good quality options for new investment in their respective areas. They should all be considered long term investments meaning five years plus and are provided for your information but are not a guide to how you should invest. Before investing in any fund please read the relevant Key Investor Information Document or Key Information Document, and Prospectus to ensure they meet with your objectives and risk appetite.
Manager James Harries is attracted to more defensive, predictable international companies that are capable of gradually growing their dividends despite what the wider economy throws at them. It can mean investing in somewhat dull businesses, but over the long term it has been a fruitful strategy. Solid, reliable businesses capable of gradually compounding returns for investors and have a low degree of economic sensitivity can provide a powerful and reliable engine of return in a portfolio.
The approach tends to lead to a portfolio concentrated in the consumer staples, healthcare and software sectors and the avoidance of areas such as mining, autos, airlines and house builders. A typical holding has ‘quality’ characteristics that the manager tries to capture without paying too much of a premium above the valuation of the market as a whole. Given the approach, we would expect the fund to underperform in a strong economic environment when more economically sensitive businesses fare best but offer more resilience in a difficult or sluggish scenario.
Manager Stuart Rhodes aims to buy tomorrow’s rather than today’s global high yielders. He is a strong believer that dividend growth drives share price growth, and that better overall returns are available from modest yielders growing their dividends quickly. At times, therefore, it may yield less than more mainstream equity income funds. However, the lack of a dividend target, plus the fact this is a global fund, affords Mr Rhodes a great deal of flexibility in terms of choosing companies for the portfolio.
It contains a core of dividend ‘bankers’, which are stable, multinational businesses in strong industry positions, but there is also exposure to disciplined companies in more economically sensitive industries to produce a well-rounded portfolio that can better keep up in rising markets compared to a more defensive equity income fund.
The level of yield provided by the UK stock market is a major redeeming feature. This fund aims to generate a dividend yield that is above the FTSE All-Share Index through a strict yield ‘discipline’. Clive Beagles has co-managed the fund alongside James Lowen since inception in 2004, longevity rarely seen in modern day fund management.
The managers seek to invest in fundamentally strong companies at an attractive price and relatively high starting yields. This promotes a naturally ‘contrarian’ style of backing out-of-favour, less expensive stocks.
The fund will typically have significant exposure to small and medium-sized companies, often giving it a different profile of holdings to many other income funds and the broader index. With a decent exposure to energy and commodities, it could also harness any increasing prices in these areas that could be a cause of persistent inflation.
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