20 May 2014
The ability of a company to pay out steady or growing dividends is often a sign of a healthy business and a good long-term investment.
Dividends provide investors with cash flows which can be used to fund a lifestyle or they can be reinvested.
These dividend payments can play an important role for investors, according to Marriott Asset Management.
A dividend is a payment made by a company to its shareholders and typically represents a portion of a company’s earnings that the directors of a business have decided to pay out and not reinvest back into the company.
The benefits of dividends are:
1. A source of income
Dividends provide investors with cash flows which can be used to fund a lifestyle or they can be reinvested. It is interesting to note that in first world markets at present, dividend yields of multinational blue chip companies are higher than cash and bond yields, making them an excellent source of current income.
2. Inflation protection
Companies that pay dividends provide investors with an effective inflation hedge.
Take, for example, an investment made in Mr Price. In 1994 a R100 000 would have bought the investor 66 000 shares in the company.
Those shares would have paid the investor approximately R2 100 worth of dividends in the first year.
In 2013 that same investor would have received approximately R263 000 worth of dividends from the same number of shares.
This increase in dividend income equates to an average annual income growth rate of 28.5 percent per annum for the past 20 years. This growth exceeded average inflation over the corresponding period by 22.1 percent per annum, the managers explain.
It is also important to note that the value of a company increases at the rate at which its profit grows. In the same way, the value of an investment grows over time at the rate at which its income grows. Mr Price’s average annual capital growth over the last 20 years has been 26.4 percent, which corresponds with the company’s 28.5 percent average annual growth in dividend over the same period, they say.
3. Companies which reliably grow their dividend tend to outperform over time
Many investors think of reliable dividend payers as stodgy, uninteresting companies that will produce mediocre returns. This is far from being the case. Studies have shown that companies which pay and grow their dividends outperform the market over the long term.
Possible explanations for why reliable dividend payers outperform include:
- the inherent optimism of people which drives investors to overpay for exciting and high-risk companies with volatile dividends, and underpay for certainty
- the large percentage which dividend income contributes to an investor’s total return over the long term and
- the fact that reliable dividend growth typically indicates that a company has a dominant brand, a strong balance sheet and a high degree of confidence that its earnings and cash flows will continue to support future payments, according to Marriott.
4. Managing tax
In South Africa, dividends are taxable in the hands of the investor at a flat rate of 15 percent. This is an advantage for high net worth individuals in higher tax brackets.
Investing in companies that pay reliable dividends helps to reduce volatility: when company share prices have declined, investors will still receive dividend payments.