This article was first published in the 3rd quarter 2018 edition of Personal Finance magazine.
Dividend-growth investing has proved popular with investors, and it has a large following in the United States, judging by the many blog sites on the topic. But what exactly is dividend growth investing, and how worthwhile is it as a long-term investment strategy?
On the surface of it, dividend-growth investing means buying shares in companies that have a solid track record of paying dividends, which have steadily increased year on year. (Note: this is very different from buying companies that are paying high dividends at the time of investing, not the subject of this article.)
The appeal is its simple (and comforting) wealth- or income-generating proposition: find a reliable dividend-paying company, invest your money and sit back and relax, knowing that, even if the company’s share price fluctuates, you or your investment will be receiving a steady dividend income that presumably keeps pace with inflation.
No, not that simple, says Lourens Coetzee, investment professional at Marriott, a boutique asset management company in the Old Mutual Investment Group that specialises in this style of investing.
He says you need to look further than a company’s five- or 10-year dividend track record. You need to make sure that the company has good prospects and will provide solid dividends in the future.
In fact, this investment style is very similar to a style known as quality investing: buying shares in good-quality companies – those that provide products or services that are in high demand, are well managed, have strong balance sheets, show resilience in market downturns, have low debt levels …
The problem is that these companies are often household names and the darlings of stock exchanges all around the world, so their share prices (or “valuations”) tend to be high, translating into relatively low dividend yields. Think Coca-Cola or Johnson & Johnson.
Few investment managers would sniff at picking up a good-quality company at a bargain price. However, Coetzee says it’s preferable to pay a fair price for a quality company with good prospects than a lower price (at a higher dividend yield) for a fair company that may have some problems. “High yield can sometimes be a trap – it might be saying that next year’s dividend will not materialise,” he says.
“We at Marriott emphasise quality, which might be lower yielding, but offers greater certainty.”
He gives as an example, in 2010, a choice between buying French beauty brand L’Oreal, which was well run and showed solid performance and, at a better valuation, English supermarket chain Tesco, an equally well-known brand, but which had some issues. L’Oreal proved the better choice: the L’Oreal share has delivered steady annual returns of 11% since then, while Tesco has been disappointing, returning –8% a year.
And this brings us to another point: dividend growth investing is not only about the dividends (although it’s the dividends that tend to “cushion” your investment returns in volatile times); it’s also about capital growth. Historically, Coetzee says, about 30% of your returns in non-property shares come from dividends and the rest from capital growth.
Coetzee says that the share price of a good-quality company will grow over time, in line with underlying growth. Importantly, these companies show resilience through market cycles: the price tends to be less volatile and tends not to dip as much in a downturn, especially if the company is a defensive stock, providing goods that people need even in tougher times, such as groceries and other consumables.
This resilience is well demonstrated in Marriott’s Dividend Growth Fund, a South African general equity fund that, according to its fact sheet, “has as its primary objective an acceptable dividend yield combined with long term growth of income and capital. To achieve this objective the fund will seek out fundamentally sound listed companies that currently pay dividends and possess the potential for consistent and sustainable dividend growth in the future.”
The worst 12-month period of the 2008/2009 financial crisis was the 12 months to the end of the first quarter 2009. In that time, the FTSE/JSE All Share Index dropped by 28.54%, according to ProfileData, with many general equity unit trusts falling by far more than that. The Marriott Dividend Growth Fund dropped just 0.04% over the 12 months.
David Nathanson, a portfolio manager at Bellwood Capital, says you can’t ignore value. He says that first and foremost you are investing to make a return, and dividends are one part of that.
“You need to understand what drives total return, and it’s yield (and that’s your dividends) plus the fundamental growth of the business (and this might tell you the rate at which dividends might grow over time) plus, very importantly, valuation.
“To chase yields at the expense of the other two is a mistake. You can’t buy a business that’s paying a 6% yield but has negative growth and negative revaluation built into the price – you’re likely to have a very poor total return.
“Dividends are a very important part of the equation, and dividend growth can be a good proxy for the yield and growth part of that formula, but investing at the expense of valuations is a big mistake.”
Both Coetzee and Nathanson are wary of grouping companies into so-called “dividend kings” or “dividend aristocrats” (see “Dividend-based indices”) and investing purely on this basis. Nathanson says that because passive funds tracking dividend-aristocrat indices have become popular, the valuations of these companies have been driven very high, and you might find that the returns of many of them could be poor in the future.
“We have looked at thousands of companies, and our portfolios are not that heavily invested in the household-name dividend aristocrats. Although they are companies you would want to own, you don’t want to overpay for them, and in our opinion they are currently priced for weak long-term returns,” he says.
You won’t get it right every time, and sometimes, even after the most careful selection, a company with a solid record may suddenly underperform or make a bad strategic move. Examples have been MTN’s Nigerian experience and Tiger Brands’ venture into Africa, both of which proved disastrous for the respective companies.
However, there are some basics to consider. If you are looking for a quality buy, Coetzee says you should be cautious of companies:
That have high debt levels;
That are heavily reliant on credit for sales;
Whose margins are coming under pressure;
That are highly cyclical in nature; and
That show poor governance.
Nathanson says you have to ask whether a company’s profits and cash flows are underpinning the dividends it is paying out, or is it returning capital to shareholders over and above profits and cash flows?
“Also, if a yield is too high to be true, that probably is not going to be the case a year from now.”
He agrees with Coetzee that high debt is a no-no. “You have to look at the balance sheet of the business. Businesses that are over-leveraged are at risk of having to cease paying dividends.”
Nathanson says a South African company whose dividend may come under pressure is Woolworths, which has a relatively highly leveraged balance sheet and which a few years ago made a huge Australian acquisition, the David Jones clothing chain, funded with debt. “For them to keep paying the dividend that they are paying, they keep putting more and more pressure on the balance sheet,” he says.
Building a portfolio
In building a portfolio you should cast a wide net, Nathanson suggests. “Don’t just look at the JSE, for example. The wider the net, the more fussy you can be about things such as balance sheets and dividends.
“Also, look beyond the mega-cap huge household names. There are a lot of quality businesses that are multi-billion-dollar companies but that are not household names, and you’re more likely to find good valuations among them.”
Coetzee says the time to pick up good-quality dividend-paying companies is when the markets are volatile, as has been the case this year. “Declines in the share prices of companies with the ability to consistently and reliably grow their dividends typically represent very good buying opportunities. When the share price is down, investors pay a cheaper price for the same reliable and growing dividend stream.
“Since the beginning of the year, the share prices of the world’s best dividend-paying companies have come under significant pressure. This has caused dividend yields to rise to attractive levels,” Coetzee says.
TAX ON DIVIDENDS
A blow for dividend-focused investors came in February last year when the finance minister at the time, Pravin Gordhan, announced an increase in dividend withholding tax from 15 percent to 20 percent. This may have resulted in good dividend-paying investments losing a little of their lustre.
Conversely, the announcement made dividend-paying investments all the more attractive for inclusion in tax-incentivised vehicles such as pension and provident funds, retirement annuities, preservation funds, compulsory-purchase living annuities, and tax-free savings accounts.
If you are interested in investing in tracker or exchange traded funds that track dividend indices, you need to know the distinction between those that simply comprise high dividend payers and those that comprise so-called dividend aristocrats, which are not necessarily among the highest payers, but which show a strong track record of dividend growth:
ALSI/JSE Dividend Plus Index (Divi).
This, according to the JSE’s website, is a dividend-yield-weighted index designed to select and measure the performance of higher yielding stocks within the universe of the Top 40 and Mid Cap indices. The index comprises the top 30 stocks by one-year forecast dividend yield.
The S&P South Africa Dividend Aristocrats Index.
This index is designed to measure the performance of companies within the S&P South Africa Composite Index that have followed a policy of increasing or maintaining stable dividends for seven consecutive years.
The S&P 500 Dividend Aristocrats Index.
This comprises companies in the S&P 500 with a track record of increasing dividends for at least 25 consecutive years. It tracks the performance of well-known, mainly large-cap, blue-chip companies. Standard & Poor's removes companies from the index when they fail to increase dividend payments from the previous year.