The enduring power of dividends

Dividends possess several key attributes that can make them a valuable addition to investment portfolios. They can provide investors with a steady income stream, which can be valuable in volatile markets. Growing dividends can offer protection against inflation, while reinvesting dividends can harness the power of long-term compounding. Importantly, dividend growth can also lead to share price appreciation. Collectively, we believe these factors establish dividend investing as a compelling long-term stock market strategy. 

Time for income to reassert itself 

Amid rising macroeconomic uncertainty and geopolitical instability, dividend strategies are increasingly in the spotlight as investors seek the comfort of safety. 

Dividends can provide some reassurance in challenging markets because the income acts as a buffer against any share price weakness. Dividend-paying stocks are also typically stable, well-managed defensive businesses that are less volatile than the wider market. 

We believe the reliable nature of dividends comes to the fore during the tough times. Dividends provide certainty in a world where capital growth is at the mercy of market sentiment. As the saying goes: “A bird in the hand is worth two in the bush, particularly during a lean spell.”

Changing market dynamics 

After two years of exceptional stock market gains, notably in the US, it’s unlikely that this performance will continue. In a world of lower returns, income becomes increasingly important, with dividends likely to contribute a greater part of the total return from equities in the future. 

“In a world of lower returns, income becomes increasingly important, with dividends likely to contribute a greater part of the total return from equities in the future.”
 

Another market shift could enhance the value of dividends. For two years, the market has been led by mega-cap US tech stocks, in particular the so-called Magnificent 7 (Mag 7). Income strategies have struggled to keep up in this narrow market environment. However, if the market broadens out beyond the Mag 7, dividend strategies, which tend to be more defensive, could offer diversification benefits to investors.

Today’s uncertain market backdrop arguably represents a favourable time for dividends to reassert themselves. Besides offering potential safety in volatile markets, consistent dividend growth offers investors protection against the ravages of persistent inflation. 

Dividends matter over the long run

As well as offering resilience in the near term, dividend investing can be a solid foundation for long-term equity returns. A small stream of income today can transform into a powerful wave over time. By reinvesting dividends and harnessing the power of compounding, investors can achieve significant gains. History shows that dividends act as a major driver of equity returns over the long term.

Over the past 25 years, reinvested dividends have constituted more than half of the total return (the combination of capital growth and income) from global equities, emphasising the benefits of long-term compounding, as the pie chart shows. 56.1% of the total return from the MSCI ACWI Index has come from income and 43.9% from capital appreciation¹. This underscores that dividends matter for long-term investors.

Dividends as a sign of quality

Dividends also matter because they are illustrative of a company’s quality. Consistent dividend growth is difficult to achieve because a company has to grow its business to support a growing dividend stream. 

Dividend growth therefore provides a strong signal of a company’s capital discipline, financial strength and corporate confidence. Dividend growers are often businesses with solid business models, robust balance sheets and confidence in their future growth. A progressive dividend policy demonstrates management’s commitment to shareholder value. These qualities are often very appealing to investors. 

Historically, dividends and share prices go hand in hand

While dividends are principally considered in terms of income, they can also lead to another less appreciated outcome: share price appreciation.

Investors have a tendency to distinguish between income investing and growth investing (capital appreciation), yet these outcomes are not mutually exclusive. By investing in dividend growers, investors can potentially capture both and achieve excellent total returns over time (income and growth combined).

Companies that have consistently increased their dividends over many years have historically been rewarded with strong share price performance. For instance, in the US there’s an elite group of companies called ‘dividend achievers’ that have increased their dividend annually for 25 years or more. 

Over the past 25 years, US equities have delivered positive returns ahead of inflation on both a capital return and total return basis. The dividend achievers, on the other hand, have outperformed materially, with the capital return beating the S&P 500 Index’s total return². 

This should not be considered a coincidence; it underscores that dividends and share prices go hand in hand. Investors focused on a company’s potential for future dividend growth, rather than its dividend yield, which is a static backward-looking measure, can potentially tap into this powerful driver of long-term returns.