January 8, 2020

Owning stocks pays dividends

Pay dividends: To cause or produce good results in the future due to an investment of time, money, or other resources.

Stocks derive their value from dividends

Dividends are the cornerstone of investing; what makes a company valuable is its ability (current or expected) to generate income for shareholders. As the economy expands and the company earns more profits, that income grows. Ultimately, any stock is worth no more than what it will provide shareholders in current and future dividends. For equity investors, there are two main things to consider:

  1. Dividends greatly enhance total returns when reinvested (compounding)
  2. As a source of income, stocks outshine bonds in some important ways:
  • Equity income grows over time, while bond income does not
  • Equity capital is preserved and grown in real terms, while bond capital is eroded by inflation

The power of compounding

Reinvesting income from dividends makes a huge difference to total return over time. $100 invested in 1995 in the MSCI World index grew to $352 by 2019, and $547 with dividends reinvested. The compounding power of an extra 3-4% every year is truly astounding.

Dividends as a source of income

For someone looking to use investment income to cover their living expenses, stocks offer two significant advantages over bonds:

  1. Dividends are a growing income stream, while bond coupons are fixed. When you buy a bond, you receive a fixed coupon payment every year. When you own a stock, the payment increases as the economy grows and the company earns more.
  2. Stocks preserve capital against inflation, while bond principal is eroded in real terms. Taking account of inflation, $100 in 1995 were worth $59 in 2019! Consequently the capital of a bond investor who consumes income every year is gradually worth less and less. Stocks however preserve and increase their value in real terms, even if dividends income is used for living expenses.
Annual Income from 1 million invested in 1995 (MSCI indices):
 EuropeUKUSA
1995€22,215£32,879$26,231
2019€127,467£112,243$115,650
Growth474%241%341%
Inflation51.1%63.3%69.5%
    
Capital Value of 1 million invested in 1995 (MSCI Indices):
 EuropeUKUSA
1995€1,000,000£1,000,000$1,000,000
2019€3,921,824£2,196,474$6,272,424
Growth292%120%527%
Inflation51.1%63.3%69.5%

Dividends can decrease temporarily, and indeed they did during the recessions of 2001 and 2008, before recovering. However they are assuredly much more stable than stock prices during downturns.

 Maximum drawdown from peak (2008 crisis)
 EuropeUKUSA
Stock prices-57.3%-45.2%-48.2%
Dividends-27.3%-25.2%-27.7%

In fact, several stocks are “dividend aristocrats”, meaning they have increased their payout consecutively every year for over 25 years. Examples include well-known companies like Johnson & Johnson, Exxon Mobil, and Coca Cola. Overall dividends in the USA surpassed their 2008 pre-crisis peak in 2012, and by 2019 had grown a further 91%.

Dividend income is a powerful and often overlooked source of investment returns; it increases over time in line with corporate earnings and is more stable than stock prices during downturns. We help clients select stocks with the most attractive, stable and growing dividends to provide a consistent income, or compound the growth of their portfolio.

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