Dividend growth: the special sauce of long-term investing

LAST week, the Monetary Authority of Singapore lifted its year-long dividend cap on local banks and finance companies, allowing bigger payouts to shareholders.

The respite comes after a rather challenging 18 months for income-focused investors. The pandemic and global shutdown walloped many areas of the market that pay dividends, including airlines, hotels, energy and financials. In a spirit of caution - or, in some cases, facing questions of survival - companies suspended or reduced their dividends at historic levels. In the United States alone, 242 companies cut or suspended dividends, nearly matching the total for the previous 11 years combined.

With the roll-out of Covid-19 vaccines and the reopening of economies, companies have begun to resume payments. Many dividends have been restored or are at least under discussion. We expect many more companies will bring them back in the coming months.

SEEKING DIVIDEND GROWERS

For many investors, the search for dividend income might naturally start with companies that pay the highest yields. These companies can be sound investments, but the high yield can also be a warning sign. Companies that have very high dividends to start may not be able to sustain them. The high yield may indicate that a company is a 'melting ice cube' where its business is in decline and it is not reinvesting.

We prefer to seek out dividend growers - strong companies that we believe are likely to be even stronger in five or 10 years. We look for a company that can demonstrate the capacity and commitment to raise its dividends over time. We also look for dividend growth that matches the underlying earnings growth of the company.

Dividend growers historically have tended to generate greater returns than other dividend strategies, while also keeping up relatively well with the broader market. People assume that growth companies far outpaced dividend-paying stocks over the past decade, and that's true when you look at the highest yielding stocks. But dividend growers did nearly as well as the overall market.

In addition to providing a growing stream of income, dividend growth can be a sign of management's more rigorous capital allocation process. Because they are committed to setting aside some proportion of their earnings for investors, they tend to have better discipline and may be less likely to make some ill-advised acquisition.

Because it is reflective of growing earnings, dividend growth can also offer a measure of resilience against interest rate hikes.

THE POWER OF REINVESTED DIVIDENDS

To get a sense of how regularly reinvesting dividend payments can compound over time, consider a hypothetical $100,000 investment in a leading fast food chain for the 20 years from Dec 31, 2000, through Dec 31, 2020, with all dividends reinvested.

In this hypothetical example, the total return of the investment would have been impressive - from $100,000 to $1,057,057 - a 957 per cent gain.

Take a look at what happened with the dividends. While the value of original shares grew to $631,117 in 2020, the value of shares from reinvested dividends would have grown from $676 in 2001 to $425,940 in 2020.

The special sauce of compounding in this example lies in the growth in share count from reinvested dividends. The number of shares purchased with the original investment would have been 2,941. By the end of the 20 years, the share count would have increased to 4,926, a 67 per cent increase. For the length of the investment, dividend payments would have represented 40 per cent of the total return.

DIVIDEND INVESTORS REMAIN VIGILANT IN THE HUNT FOR INCOME

As economies increasingly normalise, we are finding a broader set of opportunities that we believe represent compelling value for investors. We look for companies that are yielding around 2.5 per cent to 3.0 per cent, and that are growing their dividends and earnings around 10 per cent or 12 per cent a year. Today we are finding a number of companies that meet those criteria across a wide range of sectors and global markets.

• The writer is investment director at Capital Group