Savers in the UK have long had an obsession with dividend-paying companies. That’s why our domestic stock market has the highest dividend yield of any country in the world — 3.3 per cent.
US companies tend to prefer share buybacks (which increase the value of shares) as a way of passing on profits to investors, rather than paying out dividends, while Japanese firms have historically been cash hoarders, although that’s a reputation that is changing.
Here, though, pages and pages are written in celebration of the investment trusts that have increased their dividend payments for 20 or more consecutive years. We forget that while that’s laudable, it’s not everything: despite the City of London Investment Trust having raised its dividend for 55 years on the spin, its share price is down 2 per cent over the past five years.
Dividends are, of course, important for those needing a regular income in retirement, so funds that invest in UK businesses to provide that steady cashflow have a key role to play.
Dividends show that a company is in good health because it has enough cash, after investing money in its business, to reward shareholders. But beware of high and unsustainable dividends. Generally, if a yield is higher than, say, 4 per cent, you could be in for a nasty shock. Check that the dividend cover (a company’s earnings per share divided by its dividend per share) is at least 1.5 times, ideally 2 times.
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Investors need to move away from the urge to prize dividends over capital growth. If you have been invested for a decent amount of time you can get by in retirement with funds that pay lower dividend yields and supplement that by taking the profits your funds have earned over the years instead. This way you may end up with more money. The most interesting and exciting part of the UK stock market are medium and smaller companies. They’re volatile, and largely rubbish for income, but you’re more likely to profit if you are invested for the medium to long term.
Companies that have to pay a regular dividend have a different focus to those that may have the luxury of investing more spare cash into long-term growth. This is one explanation for why the S&P 500 in the US outperforms the companies listed on the FTSE 100 index. At the turn of this century our blue-chip FTSE 100 was at 6,930 while the S&P 500 was at 1,469. Almost 22 years on, the FTSE 100 is 3 per cent higher at 7,138 and the S&P 500 has more than tripled to 4,555.
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Of course, add dividends on to that and the FTSE 100’s total return since the turn of the millennium is 124.6 per cent versus the S&P 500’s 317.5 per cent. But it’s still a pretty awful result.
The FTSE 250 of medium sized companies, though, has outperformed the FTSE 100 and the S&P 500. Its firms, which are less likely to pay dividends, have gone from about 6,400 in 2000 to 22,862 today.
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It’s no surprise that three of the five best-performing UK equity income funds — (investing in companies that pay dividends) over the past three years are what are known as multi-cap income funds. They can invest in large, medium and small companies, so you can get capital growth and dividends.
Instead of investing in the miner Rio Tinto, British American Tobacco and Shell, which are expected to pay one-third (£20 billion) of the FTSE 100’s total dividend payout in 2021, according to AJ Bell, you could, for example, hold the housebuilder Galliford Try, which has returned 52.75 per cent this year; the discount retailer B&M (21.5 per cent); and the kettle part maker Strix (35 per cent).
Part of the problem for investors seeking a wider mix of companies is that the FTSE 100 is too narrow. The Financial Conduct Authority (FCA), the City regulator, has relaxed the rules to make it more appealing for companies to float on the market with the aim of encouraging innovative, technology-led British firms to list in London instead of in New York. Hopefully this will help the FTSE 100 to become more attractive to people like me — but it will take time.
Meanwhile, however, savers are already starting to resist the draw of the dividend. Since the Brexit referendum, investors have withdrawn more than £8 billion from funds in the UK equity income sector and piled £33 billion into global funds.
Some argue that the best way to build a portfolio is to pick a range of the best single-country funds, say, one invested in US companies, one in European firms, another in UK stocks and others taking care of Asia and emerging markets. This, they say, is because the managers can get to know more of the companies listed on one particular stock market, instead of trying to get to grips with firms in every country in the world.
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I disagree. I am not averse to investing in dividend-paying companies, and I use FTSE 100 shares as an insurance policy just in case inflation remains high for a long time, because they are cheaper than many US stocks found in the S&P 500 so their share prices may not fall as much in tough economic times.
However I limit my stake and remain diversified, because I also invest in other cheap shares around the world through a global fund.
If you do the same, the large UK firms shouldn’t take up much more than 8-10 per cent of your overall investments. This will help you to break the dividend habit and realise that taking profits instead is a sensible option. Your retirement may thank you later.
