Boring dividends show return to rationality

Serious Money: Regular income is proving more valuable than price growth, writes Chris Johns

Vodafone is one of the most widely held companies by personal investors in Britain and Ireland. Legacies of past privatisations and the company's sheer size ensure that it regularly features in portfolios.

When I last wrote about the company in February, I suggested that its share price was unlikely to perform very differently from the broader market, which I forecast to rise around 5-10 per cent between then and the end of this year. These sorts of numbers could be described as unexciting - although, in proper context, such a description would be dead wrong.

I also suggested that a stock like AIB was likely to be as boring as Vodafone but would probably reward investors a bit more.

Some of these recommendations have been accurate, one or two less so. But their evolution raises a lot of the major issues that confront investors right now.

Should we look at telco stocks - now a major part of almost every stock market in the world - as a growth sector or as old fashioned utilities?

How important are dividends these days? What are the currency risks involved in buying British (and other non-euro) equities? What impact do corporate governance - and other "managerial" - factors have on share price performance?

Since February, Vodafone has risen by around 8 per cent in sterling terms, beating the capital return from the FTSE all-share index by around three-quarters of a percentage point.

Adding dividend payments, we find that Vodafone has yielded a total return of 10.5 per cent, while the broader market has returned nearly 11 per cent.

The telecommunications giant has been upping its dividend - recently doubling the interim dividend payout - but the stock's yield (currently about 2.75 per cent) still falls short of the overall market's dividend of nearly 3.5 per cent.

The difference in dividend yields may not seem like much, but over the long haul it could be hugely significant.

The doubling of the dividend was significant in a number of respects. It reflects the astonishing level of cash that the company generates - cash flow from operations reached £6.4 billion (€9.1 billion).

Vodafone also uses its cash to buy back a lot of its shares, which is another sort of dividend payment - shareholders end up getting cash, but via a different route.

If Vodafone is to match the dividend of the other British telecommunications giant, BT, it will have to double its payout again.

Companies that have high and stable cashflows are usually called utilities. They are often dull entities since they are relatively immune to the vagaries of the economic cycle.

Provided they reinvest in their businesses in a disciplined way and return what's left to shareholders they can be relied on to pay - and sometimes grow - their dividends. Managerial pretensions - such as a merger or acquisition splurge - are often punished by shareholders.

These sorts of companies are relatively easy to value: the actual dividend payment is by far the largest driver of valuation rather than some half-baked guess about future growth rates.

For obvious reasons, AIB has not been the boring story that I forecast, but it has nevertheless managed to beat Vodafone.

The bank has risen by around 9.5 per cent in capital terms and dividends paid during the period have brought the (gross) total return up to nearly 14 per cent.

This compares, in terms of the euro (remember that the figures quoted above for Vodafone were in sterling terms), to capital and total returns from Vodafone of 4 per cent and 6.5 per cent respectively.

Sterling's fall against the euro is, of course, making a material impact on returns. AIB's current yield of around 3.8 per cent is higher than Vodafone's, but the British company is almost certainly going to grow its dividend at a faster rate than will AIB.

This point about growth is critical to valuation. If a company is not expected to grow very much we can look at current dividends and make a very good stab at correct share price.

If growth is a big part of any corporate story, we have to place a value on the likely rate of expansion - and how long we think that growth will last (no company can be high-growth forever).

These guesses about growth are enormously important drivers of share price valuation and are extremely difficult to make.

AIB's growth prospects are mostly linked to the Irish economy (particularly its housing market), the degree of banking competition, and growth opportunities overseas.

Competition and, perhaps, regulation mean that AIB cannot meaningfully grow its domestic market share. Competition is also leading to margin erosion.

Hence, domestic profits growth requires lending growth to be sufficiently fast to outweigh falling margins.

It can probably pull off this trick for as long as the housing market remains sound (but watch problems come from nowhere once that market turns).

The new chief executive at Bank of Ireland was applauded for his brave promises on cost control, but the absence of much discussion of growth was revealing.

Irish bank stock market ratings are low because it is not at all clear where the growth is going to come from. That Vodafone has growth prospects is clear, but nobody has a clue what they are; hence, we don't think it worth putting too high a share price premium on them.

But it does stand a chance of growth if all the rosier projections of 3G demand come to pass.

And, a small point, it is still a growing company: sales growth rose by 6 per cent in the most recent results.

But growth is sadly absent, as far as I can tell, from that other familiar telecommunications company, Eircom. Total turnover was down, as was market share of fixed-line business.

The market's willingness to buy into the growth promises of broadband and re-entry into wireless telephony remains a huge mystery to me. Eircom's protection is, of course, its dividend: the fact that its share price has just about crawled over the IPO price is testament to the current power of dividends.

But any company that sees top-line revenues shrink will, if it goes on for long enough, ultimately have to cut its dividend.

Dividends were not terribly sexy for much of the last decade. But their move to centre stage - even Microsoft gives money back to shareholders now - represents a return to more rational analysis and a recognition that, historically, dividends have rewarded shareholders much, much more than simple share price appreciation.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.