Investors are often tempted to buy shares which promise bumper dividends today, largely because they need the income immediately, perhaps to support early retirement.
Those who can wait longer may want to consider an alternative – investing in companies that offer the potential of fast dividend growth.
Companies which can grow their dividends rapidly can deliver far better returns than today’s higher yielding stocks, but investors need patience as we explain below.
What is dividend yield?
Yield is the income an asset generates divided by the asset's capital value. If company A's shares are worth £10 each and it pays an annual dividend of £1 then its dividend yield is 10%.
What is dividend growth?
Dividend growth is the amount the dividend grows year-on-year. If company A pays £10 in year one then £11 in year two its dividend has grown 10% year-on-year.
Yield or growth: what’s more important?
In the example below, we make two hypothetical investments of £10,000 in company ‘A’ and ‘B’. We assume dividends are reinvested. We also make the bold assumption that the share price of each stock won’t move, to remove them from the equation. The reality, as we all know, is that share prices can be volatile and can rise and fall.
- Company ‘A’ starts with a dividend yield of 3% and grows its dividend by 10% per year.
- Company ‘B’ starts with a dividend yield of 7% and grows its dividend by 3% per year.
After 22 years, the investment in company ‘A’ starts to outperform. After 25 years, the investment in company ‘A’ is worth £153,000, compared with £113,000 for company ‘B’ – a 35% difference.
Where can I find sustainable dividend growth?
Nick Kirrage, an equity value fund manager at Schroders, said: “It may come as a surprise that one of the best sources of dividend growth come from companies that have actually cut their dividends. Dividend cuts reflect both past difficulties and future potential.
“They are rarely welcomed by investors, so when companies do cut their dividends their share prices tend to fall significantly as a result.
“However, history shows that over time share prices recover and dividends grow much faster than the market expects.”
As an example, Legal & General was forced to cut its dividend during the recession. The business’s share price suffered badly, falling to 23p at its low in 2009.
However, as can often happen at times of panic, these fears were significantly overplayed and today the group’s share price is around £2.70 and it has raised its dividend by at least 15% in each of the last five years.
This situation also highlights that there are no guarantees when it comes to companies paying dividends. Investors might prefer to invest in bonds, which pay a more stable dividend.
Do I prioritise dividend growth potential over current high income?
Investors need to reach a balance. Kirrage said the ideal stock would meet three objectives – a high dividend yield but with the promise of capital growth and dividend growth. In reality, he says, few shares can match all three criteria.
“As an investor you want to find shares in a certain sweet spot,” he said. “You want a cheap share price, high income and high dividend growth. But every other investor also wants this. You normally have to sacrifice something.
"For us as value investors, we might buy a bank with no dividend yield. Banks are cheap and have the potential to rapidly grow dividends. Many have been reinstating payments after a period of no dividends.”
As well as banks, Kirrage also considers some miners and supermarkets, such as Tesco in the UK, to be candidates that are close to the sweet spot.
- For more of Nick Kirrage’s investing ideas, go to The Value Perspective or sign up for the newsletter
If I need high income today, can I trust the yields on offer?
Income investors should pay attention to “pay-out ratios”. These hint at whether a company, or sector, can afford to keep paying dividends at the same rate.
The pay-out ratio is the proportion of profits a company is using to pay dividends. The higher the pay-out ratio the more of its profits a company is using to pay the dividend. High pay-out ratios can put dividend growth at risk and even threaten the viability of future pay-outs.
A good fund manager will include this as part of their analysis when selecting stocks.
The chart below shows the range of pay-out ratios for different stock market sectors between 1987 and September 2016 with the orange line marking the average. The yellow dot shows the ratio at the end of that period. The data covers developed markets, excluding the US.
Consider the example of the financials sector, which is made up largely of banks. It had a relatively low pay-out ratio compared to other sectors and compared to its own typical range. Energy stocks, in contrast, had a very wide historic range and were at the very top end of it.
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