Serious Money:George Soros, the enormously successful financial speculator, highlights capital preservation as an essential prerequisite to lucrative investment. He writes in Soros on Soros that his fundamental investment principle "is to survive first and make money afterwards".
Stock investors should heed his words as concerns over the economic impact of the US's deepening subprime crisis has not only contributed to a resurgence of market volatility but has also brought the almost five-year-long upswing in share prices to a halt.
Investors should focus on dividends as the outlook for continued capital gains looks less promising and the income will provide a welcome boost to returns. It is important to recognise that dividends have always been an important component of stock market returns and, along with their reinvested returns, have accounted for more than a third and roughly one half of nominal and real returns respectively over the past 80 years.
Their significance seemed to be dismissed during the heady days of the 1990s as performance-chasers poured monies into "glamour" ... ... ... ... ... ... ... ... ... ... ... ... ... ... stocks and sectors. However, investors learned to their cost that they are and always will be a central indicator of fundamental value since they represent cash paid to shareholders and, unlike earnings reports, dividend cheques don't lie!
Recent research illustrates that dividend-based investment strategies have outpaced the broader market through time. Research Affiliates, a California-based investment management firm, has conducted a study that shows an index weighted by dividends as opposed to market capitalisation has outpaced the latter by almost 1.5 percentage points per annum over the past 40 years while volatility has been considerably lower.
Furthermore, the dividend-weighted index has produced superior returns relative to the S&P 500 in almost all macroeconomic environments including economic expansions, recessions, periods of rising interest rates and periods of declining rates. The incremental annualised performance since the early-1960s was roughly 100, 460, 230 and 90 basis points for each macroeconomic climate respectively. The volatility of returns was lower in all cases.
The dividend-weighted index also generated a performance advantage of almost nine percentage points during bear markets though it lagged the broader market by almost one percentage point during bull markets. However, this can be explained by the "tronics boom" of the early-1960s and the "dot.com bubble" of the late-1990s - unlikely to be repeated soon.
The notion that a dividend-based investment strategy produces superior returns is confirmed in various studies. Ned Davis Research notes that dividend-paying S&P 500 stocks have outpaced non-dividend paying stocks by almost six percentage points per annum since 1970. The S&P Dividend Aristocrats Index, which includes 57 companies that have increased their dividend annually for the past 25 years, has outpaced the market by six percentage points a year since 1969. Other studies confirm that the dividend effect has been present across other markets and regions.
Financial theory suggests that investors should not be able to secure higher returns without bearing higher risk. However, the evidence confirms that a dividend-based strategy has historically delivered higher returns with lower risk.
The explanation appears to lie in how investors view high dividend-paying companies and how management teams treat dividends. Investors are constantly assessing a company's ability to grow. All else being equal, growth hinges on the proportion of profits a company distributes to shareholders and the rate at which those profits not distributed are reinvested in the business. Consequently, firms that pay out a high percentage of earnings to shareholders are often deemed to have few growth opportunities while those with a low payout ratio are thought to have an abundance.
Misguided valuation multiples are afforded accordingly. However, historical evidence shows that investors' beliefs are false as high payout ratios do not lead to lower future growth and vice versa. This is because companies use dividends to signal their long-term earnings power to investors and the credibility of an increase lies in the fact that, if a firm increases its dividend without the expectation of higher future profits, it will have difficulty sustaining the higher payout and the ultimate cut that follows could cost senior management their jobs. Thus, dividends impose financial discipline on a company's senior management and they exercise greater caution in the investment process. Consequently, the quality of investments tends to be better and combined with the valuations afforded by investors, translates into higher stock market returns.
Dividend-based investment strategies have performed well through time and particularly during bear markets, economic recessions and falling interest rates. The current turmoil has led to expectations of a rate cut while the probability of both a bear market and an economic recession has increased significantly. Investors should look to dividend stocks to enhance returns.
