Turbo-charge your portfolio by investing in rising dividends

But investors should also keep a close eye on valuations

ONE OF the simplest ways of accelerating long-term capital growth is the old trick of reinvesting dividends. According to BlackRock, £100 invested in a FTSE All-Share index fund in 1987 would have been worth almost £900 at the end of 2012 with dividends reinvested, compared to just over £350 if dividends were taken as income (see chart).

But research by JP Morgan suggests that (rather than accepting a steady payout from a blue-chip stalwart), investors should look out for stocks that increase their dividend payment year-on-year. Not only could this limit the effects of inflation, but by focusing on these companies, investors could have grown their capital 20 fold since 1988. Not many companies fit the bill, but stocks like L’Oreal and Exxon Mobil have had a particularly strong track record to date.

“Reinvesting a consistent, growing dividend is an excellent way to magnify returns,” says Michael Clarke, a fund manager at Fidelity. “What you can’t afford is a cut to dividend payments – consistency is key.” Crucially, stocks that have high payouts at a given time are not always best in the long term. Hansard Global and Man Group, for example, currently yield 13 and 12.5 per cent respectively, but neither make JP Morgan’s list of dividend stalwarts.

The research highlights Royal Dutch Shell, which yields 5.29 per cent at the moment. Aside from 2008, the company has not cut its dividend payouts since World War Two. And some of the best dividend payers come from abroad. There is a “perception among investors that the US lacks a focus on dividends,” says Fiona Harris of JP Morgan. “But companies like Wells Fargo and Procter & Gamble have long been excellent in this regard.” The average dividend increase for the S&P 500 has been 28 per cent since the beginning of the year, compared to single digit growth for UK-listed companies.

“But it’s also important that investors look at valuations and payout ratios,” Harris says. A surge in the stock price could make a hitherto strong yield look relatively unattractive, and dividend income may be better reinvested elsewhere. Harris says that her team does a lot of portfolio trimming based on valuations, stripping out stocks that look expensive, as well as those that look to be paying an unsustainable rate of dividends. “Stocks below the payout ratio of around 50 per cent, and with a yield between 2 and 4 per cent, hit the sweet spot for us.”

But dealing charges can stack up if you’re not reinvesting dividends through an accumulation fund. Jason Witcombe of Evolve Financial Planners points out that “if you’re being charged close to £10 per trade, this could get expensive over time.” Using an Isa, meanwhile, can help to avoid complicated and potentially costly taxes. “Pursuing this strategy outside of an Isa leads to extremely messy capital gains tax calculations,” Witcombe says. “You would need to keep a very detailed book at the time of each order.”