Why Should You Be Focussed on Dividends?

Get Ready for 5 Per Cent…

Yesterday Dan discussed the power of dividends and how reinvesting them, through the magic of compounding, leads to massive outperformance over a long period of time.

He also pointed out such a statistic was hardly one that would fire you up. After all, in a world where one week is long term, who can think 20 or 30 years into the future? Human nature being what it is, those with enough time think they know better and those without it wish they could wind back the clock.

Today we are going to throw our two cents on the matter into the ring. Because if you care about the next 20 years (and not just the next 20 minutes) it’s a very important topic.

Why should you be so focussed on dividends? Because for years they have been of secondary concern. Most investors have just lived through a 25-year bull market – if we take 1982 as the starting point and 2007 as the end point.

That’s 25 years where capital gains were the main source of an average return. Dividends were just a bit of a bonus, but not the main game. Capital gains were so dominant as a source of returns because of the secular decline in interest rates. This in turn occurred because of falling inflation, globalisation and the ability of governments to manipulate inflation statistics to suit their needs.

In security analysis speak, falling interest rates equated to a falling ‘equity risk premium’. Investors began to view stocks as less risky than before. Instead of paying 8 times earnings for a company, investors were willing to pay 20 times earnings. That’s a 150 per cent capital gain right there just from a change in perception.

And then of course falling inflation had the effect of encouraging borrowing. Debt levels increased. This leverage provided another boost to company earnings. When you get higher earnings multiples placed on rising earnings you quickly forget about the importance of dividends.

But that game is now over. In a bear market, things go the other way. Earnings multiples shrink as the equity risk premium rises. Notice though how this is happening even before interest rates start to rise. This is a deflationary re-evaluation of risk, not an inflationary one.

In addition to a shrinking multiple of earnings, actual earnings contract too as a combination of deleveraging (i.e. no credit growth, or credit contraction) and government interference play havoc with companies’ attempts to grow.

Suddenly divvies start to look enticing. Actually, it’s not sudden at all. Investors take a while to realise the bull market is long gone. It’s been just on four years since the market peaked back in November 2007 and we’d guess there are plenty of punters who think the next bull market is just around the corner. Maybe they think we turned that corner today?

And having a massive financial industry that was created out of the last bull market makes it difficult to effectively communicate the reality of the situation. There’s no shortage of self-interested opinions telling people (as they’ve been doing for the last four years) that every pullback is a buying opportunity.

So in a world where long-term capital gains are all-but non-existent, dividends will again receive the respect they deserve.

Bill Gross of PIMCO didn’t say all this exactly in his latest investment outlook but the gist was the same:

…investors should recognise that Euroland’s problems are global and secular in nature, reflecting worldwide deleveraging and growth dynamics that began in 2008. It will be years before Euroland, the United States, Japan and developed nations in total can constructively escape from their straightjacket of high debt and low growth. If so, then global growth will remain stunted, interest rates artificially low and the investor class continually disenchanted with returns that fail to match expectations. If you can get long term returns of 5 per cent from either stocks or bonds, you should consider yourself or your portfolio in the upper echelon of competitors.

A 5 per cent long-term return from the stock market sounds pretty ordinary. But that’s the thing – a bear market is not ordinary. It’s worse than ordinary. As Dan mentioned yesterday in his article on reinvested dividends , in a bear market your job is to not lose money. Keep your capital intact and get ready to have a swing when the next cycle gets underway.

How do you do that? Well, you could do worse than keep reading the Markets and Money. If we’re wrong it won’t have cost you anything. And you’ll always have someone else to blame.

Bill Gross has the following suggestions to get you to reach the upper echelons of investment performance – a 5 per cent long-term return. Although we’re not so sure:

…risk assets in developing as opposed to developed economies should be emphasised. Consider Brazil with its agricultural breadbasket and its oil. Consider Asia with its underdeveloped consumer but be mindful of credit bubbles.

What, like the credit bubble that is in the process of bursting in China?

Yes that’s the one. But China’s authorities are on the case too. They are easing monetary policy…bringing the jumbo jet down to the runway ever so softly…we’ll have more on that nonsense tomorrow.

In the meantime, as the central banks continue to wreak havoc with everyone’s money… are you ready for long-term returns of 5 per cent?

Greg Canavan,
for Markets and Money

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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What happens when the companies in question start cutting dividends due to poor profits and losses?

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