Investing for income: what you need to know about dividends

Investors tell themselves they are investing for the long term, but that doesn’t seem to make it easier to digest the ups and downs they see in their portfolios on a monthly or yearly basis. They fret over every dip and sulk over every lost opportunity and suddenly, taking a long-term view is not so easy anymore.

A focus on dividends might sound like the classic strategy for impatient investors who want to start receiving income from their investments as soon as possible. This is one of the great benefits of a portfolio with a high dividend yield, but research shows that investing in global companies able consistently to pay and grow their dividends, rather than focusing on the highest yield, is the most effective way to boost long-term returns and grow your investment. The reliability of returns generated from consistent dividends and dividend growth also reduces investment risk and volatility.

Research shows that approximately 80% of long-term US equity returns over the last century have been delivered by dividends and dividend growth*. This means that over five years dividends and crucially dividend growth are the key elements of absolute return, and change in valuation becomes less important. If the investor chooses to reinvest the dividends received, the portfolio can also benefit from the compound growth achieved through increasing the amount of money invested over time.

These companies’ stocks also tend to be much less volatile than global equities in general. In fact, they can be anywhere from 20% to 40% less volatile than the market. A further benefit to investing in high-quality companies is therefore the resulting minimisation of the volatility drag – in other words, losing less money on the downside makes it easier to grow wealth over the long term.

When building a portfolio of dividend-paying companies, many investors make the mistake of focusing exclusively on stocks with the current highest yields. A high dividend alone does not mean a company will be able to grow over the long term or be able to continue to generate returns even when economic growth slows down. Over the period of a year, factors like market sentiment can change and push share prices in a new direction, but over a longer period it is impossible to continue to fake good dividends and cash flow.

This is why investors have to look for high-quality companies which can offer not only dividends, but can continue to pay and grow those dividends. This requires strong balance sheets as well as the ability to generate cash even when the economy they do business in is slowing down. This may be a company operating in a market with high barriers to entry, a company that is able to continue to generate further income from a product following the initial sale or a company with enough pricing power to adjust its prices along with rising inflation. When market tailwinds are strong, many companies look good and it is easy to identify strong performers, but what is more important is seeking companies that will remain resilient.

These companies are not in a specific sector or region. They are hidden anywhere and everywhere, but to be immune to effects of dips in any local economy they often operate globally. Investors need to look for ‘transnational’ companies that do not derive their revenue from a single market but instead have operations and senior executives spread throughout the world. A global approach affords investors the flexibility to better navigate regional trends.

Such companies have the ability to access emerging markets and other higher-growth areas using local expertise and they do not derive their revenue from one market. The location of their headquarters has little to do with where they generate revenue. Flexibility to select high-quality stocks from around the globe can offer some consistency and help protect a portfolio against secular slowdowns. The bottom line is that such companies must be robust enough to continue operating even if the local economy declines.

At the same time, the long-term investor cannot simply look at a company’s growth in earnings to determine its growth potential. They need to also look at its cash flow statement and the balance sheet and take into account the cost of growth – that is how much cash a company has to keep in order to invest to generate growth in income or earnings.

This may mean that the investor ignores a rising share price on the back of strong increases in company earnings. If the choice is to invest in high-quality companies, the portfolio won’t always race ahead with the rest of the market, but when the market turns it is also unlikely to fall as hard as the market. This approach means that world indices are no longer a target to chase, but rather an indicator of where possible global investment opportunities may lie.

While there is no guarantee dividend-paying stocks will continue to pay dividends in the future, we believe that quality, with a focus on companies that can grow earnings and free cash flow with a commitment to return cash to shareholders, is a key aspect of successful dividend investing during low-growth environments.

Fund managers often measure their success relative to a benchmark index when they should care about performance in real terms. Risk is not the possibility that you will not measure up to a benchmark of how everyone else is performing, but rather is the possibility of losing the money you invested. This means that market trends are less important and short-term fears will fade away with much more ease.

*Source: research note by GMO, in August 2010.

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The Allan Gray-Orbis Global Equity Feeder Fund remains fully invested in global equities. The objective of the Fund is to outperform the FTSE World Index at no greater-than average risk of loss in its sector.