Using Dividends To Generate Income

07.09.10

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With bank interest rates stuck at historic lows, many investors are looking for alternative ways to generate income. When investing your capital, it is important that your portfolio is designed a

With bank interest rates stuck at historic lows, many investors are looking for alternative ways to generate income. When investing your capital, it is important that your portfolio is designed around your specific needs for income and growth.

Many portfolios focus on growth even if income is a requirement. In this case units are sold to generate income, which is all well and good if values have risen enough to compensate for the amount sold, but if not you will have less capital working to provide further growth and future income. There is the risk that you could be left with little capital or income in the long run.

Alternatively you could structure your portfolio with the aim of generating sufficient natural income from the assets to meet your ongoing income needs. This significantly reduces the risk of having to sell longer-term inflation protection assets and strip out capital.

Bond funds are a tried and tested means of generating natural income. A high yield bond fund would normally produce higher income than a bank account and can also offer the potential for capital growth over the longer term.

Another means of generating natural income is through buying shares in companies which pay dividends and which can be expected to keep making dividend payments and, ideally, to increase them.

Shares of companies which pay high dividends tend to provide capital growth, as well as income, over the medium to long term.

This seems counterintuitive and you may expect a dividend paying share to translate into low growth since the company has less cash available to grow its business. However, the fact that a company pays a dividend can be seen as a sign of corporate strength in that it can release cash to investors by way of a dividend because it is confident that the business plan for growth is not contingent on further capital outlay.

One of the primary roles of a public company?s management team is to allocate capital among various projects in order to maximise returns for shareholders. These capital allocation decisions are one of the critical long-term driving forces for company success ? and therefore ultimately for share performance.

One indication that management takes capital allocation seriously is through its dividend policy. A dividend crystalises a portion of the company?s earnings for shareholders, whilst retaining those earnings within the company does not.

A study by Robert D Arnott and Clifford S Asness entitled ?Surprise! Higher Dividends = Higher Earnings Growth?? in February 2003 established that companies with higher pay out ratios e.g. dividends actually have higher real earnings growth over the following 10-year period.

It analysed data from the S&P 500 index over the years 1946 to 2001. Over every rolling 10-year period the highest dividend payers had the highest earnings growth. These results were not just on average, but were robust though the strongest and weakest markets as well.

This does not mean it is not possible for companies to have high earnings growth if they do not pay dividends. Most of the growth companies which produce annual growth rates of 20%, 30% or more do not pay dividends as they need the capital to sustain their investment opportunities. However growth rates of this magnitude are rare and not sustainable over the longer term so you would need to be very skilled at analysing high growth companies to be able to successfully navigate this segment of the market.

The relationship between dividends and growth is not confined to the US market. Studies replicated in other countries have produced similar results. For example, looking at the UK, Germany, Japan, Switzerland from 1973 to 2004, companies in the top quartile for paying out dividends went on to produce the highest earnings and highest dividends over the subsequent five years.

The results were consistent with the Arnott and Asness study, providing robust evidence that this phenomenon is worthy of attention when analysing the long-term expectations of shares.

Other studies have produced similar results. For example Ned Davis Research, a highly respected investment research house, looked at the performance of US companies from 1972 to May 2010 and found that those which consistently raised their dividend returned 9.3% annualised. This compared to 7.1% for those which paid dividends but did not increase them each year, and 1.4% for companies which did not pay any dividend.

Another benefit of dividend share is that they tend to outperform with less volatility than non-dividend payers. In down markets, high dividend shares are usually the better performers as a decent payout level can help to protect a share price.

This style of investing is therefore appealing for investors looking for an element of capital preservation in down markets as it can result in more stable returns.

When it comes to choosing which shares to buy, your research should examine the key business drivers for future dividend growth. You should look for companies trading at discounts to their intrinsic values and the management?s willingness and ability to pay higher dividends in the future.

You would need to be experienced investor, and have the time and means to carry out such thorough research. Alternatively you can invest in a high dividend equity fund, where the management team would do all the research for you. This could entail the manager calling a company?s customers, suppliers, distributors and competitors and could also involve in-depth meetings with management to find out if their interests are aligned with shareholders.

A skilled manager would look for companies that can balance the goals of paying an attractive dividend and finding future growth projects. He would look beyond high dividends to other sources of return so that the fund can participate strongly in rising markets, thus increasing potential return.

Any investment decisions should be based on your specific objectives, circumstances and risk tolerance. An experienced wealth manager like Blevins Franks will advise you on whether a high dividend fund would be suitable for you and also discuss other options for income and growth.

By Bill Blevins, Managing Director, Blevins Franks

1st September 2010

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.

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