Polar Capital

The importance of growing dividends

Dividend growth is an important driver of long-term equity returns. Within equity markets, the rallying of bonds usually prompts market strategists to focus on bond proxies, equities that behave like a bond with low sensitivity to the macro backdrop and reasonable dividends. We see, however, a critical distinction between ’true’ and ’perceived’ bond proxies.

Ex-growth companies with flat and high dividend yields are ’true’ bond proxies. With no growth in their underlying earnings, these types of stock are effectively risky bonds. Investors are not guaranteed their principal back, and the ultimate return is heavily dependent on the multiples paid at purchase and achieved at exit. This leaves investors exposed to broader market de- and reratings.
In comparison, a ’perceived’ bond proxy is a stock with regular, albeit unspectacular, growth. This dull growth is underpinned by a strong business model and the stock has a low earnings sensitivity to the generic macro cycle. A cheap entry point into this profile of stock results in a combination of a valuation margin of safety and dividends that compound over time
Investors must be wary of optically attractive, high, ex-growth dividend yields. In a world starved of yield, markets are not yield inefficient. A 9% dividend yield is often too good to be true and investors should therefore consider other valuation metrics in order to assess how attractive the price really is.
It is also worth highlighting that a more modest but growing dividend stream will become a higher-yielding stock over the medium term. A 4% yielding stock with 6% growth yields the same amount per share as a 6% ex-growth stock by the seventh year of growth. Moreover, the 6% growth is likely to translate into capital appreciation from a rising share price.
Reasonable if unspectacular earnings growth protects investors against the effects of market deratings. A stock with growth will be on falling P/E multiples as the earnings base compounds higher over time. Over longer timeframes, this compound earnings growth can materially outweigh the effects of a lower valuation multiple.
Picking out-of-favour companies is central to finding stocks with good yields and still reasonable growth. The dividend yield of a stock will be inversely correlated with investor sentiment regarding that stock. Loved growth stocks will typically be priced for perfection with investors accepting no or a very low dividend because of promised strong future growth. Conversely, when stocks are hated dividend yields will be much higher to entice investors to buy the shares.
We try to buy stocks when their cash flows are cheap (ie their dividend yields are high) and sell them when their cash flows are expensive (ie low dividend yields). Good and growing dividend payers typically strike a good balance of retain and return: companies that generate sufficient cash flows to pay a reasonable dividend, but also reinvest in their businesses for future growth. A common mistake in income investing is to get this balance of retain and return wrong.
When looking for long-term equity returns it is crucial to look for companies with growing dividends. Therefore, it is crucial to focus on stocks that provide regular, unspectacular growth instead of high-yielding, ex-growth stocks.
Nick Davis
23 April 2019

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