How dividend growth can help to boost total returns

Most investors tend to think of income investing as a matter of finding the fattest yield and harvesting the dividends. But our research shows that it is consistent dividend growth that really matters when it comes to generating the best total returns from a portfolio of shares, at least if history is any guide.

Since its inception in 1962, the FTSE All-Share index has generated a compound annual growth rate of 6.8% a year.

If you were to put your full ISA allocation of £15,240 and be able to bank that historic compound annual return for 20 years you would end up with £56,808 – although I must point out this figure is before adjustments for any dealing expenses or taxes.

That is pretty good going and has beaten the retail price inflation (RPI) in the UK by 1.2% per annum on a compound basis over the last 50-odd years. It helps support the view that equities (stocks and shares) can provide a good defence against the evils of inflation.

But the numbers look very different if you then take into account both dividends and capital gains. If you were to also rake in the FTSE All-Share’s average 3.8% dividend yield on top of that 6.8% annual capital return and then reinvested those payments, the end result is £114,331, again before adjusting for any dealing expenses or taxes.

Dividends and their reinvestment can help to augment total portfolio returns

Source: Thomson Reuters Datastream. Assumes initial full ISA allocation of £15,240 and no further contributions. Does not adjust for any dealing costs or taxes.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

That is how income investing can be so powerful. You can do it by either picking stocks yourself or getting an income fund manager to do it for you (albeit in exchange for a fee) and choosing the accumulation rather than income units, so the fund’s dividend payments are reinvested rather than handed over to you on a quarterly, semi-annual or annual basis.

But as we shall now discover, the power of income investing can go even deeper than that, once you start to look at dividend growth.

Decade of dividend dynamos

Again, most investors think income investing is about spotting the fattest dividend yields and that is one approach that can work – providing you do your research on those stocks to reassure yourself those payments are safe and reliable.

But history actually shows that the best total returns come from stocks which prove capable of consistently growing their dividends rather than knocking out a fat unchanged payment each year.

Over the past decade, 26 current members of the FTSE 100 have increased their shareholder dividend each and every single year.

• The average share price gain from those 26 firms has been 265.3% since 1 January 2016 – compared to a 9.2% advance in the FTSE 100 over the same time period.
• The best performers – Paddy Power Betfair, ARM and Compass – have risen by 981%, 716% and 449% respectively. Even the worst of the 26 – SSE, Pearson and BAE Systems – have beaten the index with capital gains of 44.2%, 39% and 29.6%.

All of the FTSE 100’s ten-year dividend growers beat the FTSE 100’s capital return between 2006 and 2015

Source: Thomson Reuters Datastream, Company accounts
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

On 1 January 2006, the 26 names were offering an average dividend yield of 2.8% between them, based on the dividend ultimately paid in 2006. At the time the 26 were offering a prospective dividend yield of just 2.8%. Had investors known what dividends the 26 would offer in 2015, they may have been astounded (and delighted) to see that they were going to provide an average 9% yield, with Next offering 26%, Paddy Power Betfair 18.3% and Compass 13.3%. This chart looks at what would have been the highest 10 yields based on 1 January 2006’s share price and the actual 2015 dividend.

Dividend growth should eventually pull the share price higher as the yield attraction builds

Source: Thomson Reuters Datastream, Company accounts
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Do your own research

This may all look simple, but unfortunately there is no such thing as a free lunch, and picking out ten-year dividend growers is not quite as easy as it sounds for two reasons:

• First not all of the firms in the above list were in the FTSE 100 in 2006, with DCC, Paddy Power Betfair and St James’s Place being just three examples of firms who have risen through the UK’s corporate ranks. Many others have been mainstays of the benchmark, including Sky, Diageo and Johnson Matthey but you may need to do some work on the FTSE 250 as well as the FTSE 100.
• Second, the past is no guarantee for the future. Pearson has already suggested it will freeze its dividend in 2016 a and a number of other firms have recently brought to a halt terrific runs of dividend growth with some equally dramatic cuts, including Tesco, Sainsbury, Rio Tinto and BHP Billiton. The results are not pretty.

Pearson’s shares have suffered as tough trading points to a dividend freeze in 2016...

Source: Thomson Reuters Datastream, Company accounts
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

... while shares in grocer Tesco...

Source: Thomson Reuters Datastream, Company accounts
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

... miner Rio Tinto...

Source: Thomson Reuters Datastream, Company accounts
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

... and miner BHP Billiton have all been hammered as earnings have faltered and good runs of dividend growth given way to payment cuts

Source: Thomson Reuters Datastream, Company accounts
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

It is therefore important to check earnings cover the dividend and make sure a company is not having to strain to keep its run going, as diverting cash to fund the distribution and away from investing in the day-to-day business could weaken a company’s long-term competitive position – and it strength here that ultimately provides the pricing power which in turn provides the consistent cash flow that makes the payments possible.

This table summarises the dividend cover on offer, based on 2016 consensus analysts’ forecasts for 2016, to give you a starting point for your own studies. A few of these stocks do offer skinny dividend cover and more are showing a marked slowdown in their rate of payment growth, so there has to be a good chance that some of this list of 26 fail to make the grade in 2026, even as a few more join this elite income grouping.

Source: Thomson Reuters Datastream, Company accounts

Pick your own style

One final point to note is that a strategy that involves researching stocks in great detail and then holding them for 10 years or more may not appeal to, or work, for you.

If you’re in drawdown, for example you make prefer to take the cash and just focus on high yielders and capital preservation rather than capital growth and income. Equally, you may not have the time or confidence to do the research, though at least a fund can help here and the choice to buy accumulation (acc) units rather than (inc) ones means you can reinvest those precious dividends.

Ultimately, what works best for you will be driven by your overall strategy, target returns, time horizon and appetite for risk.

Russ Mould
AJ Bell Investment Director