How to harness the power of dividends

“The true investor… will do better if he forgets about the stock market and pays attention to his dividend returns.” – Benjamin Graham

Dividend income has always been one of the key contributors to equity-market returns, especially in periods of volatility or bear markets. In the 1970s and 2000s, both periods of significant market volatility for the S&P 500, virtually all of the index’s returns came from income, according to data compiled by Bloomberg and Guinness Global Investors. In the 1970s, the index recorded growth of 76.9%, with 17.2 points coming from price appreciation and 59.7 from dividend income. In the 2000s, the index fell by 24.1%, but dividends added 15 points for a total return of -9.1%.

The longer one stays invested, the more critical dividends become. Guinness Global’s data, going back to 1940, reveal that, over rolling one-year periods, the total contribution from dividend income to total return was just 27%, but that number grew to 57% over a rolling 20-year period. They also reveal that $100 invested at the end of 1940, with dividends reinvested, would have been worth approximately $525,000 at the end of 2019, versus $30,000 with dividends paid out. In this period, dividends and dividend reinvestments accounted for 94% of the index’s total return.

The same trend has been observed in the UK. Between 1 January 2000 and 31 December 2019, the FTSE 100delivered an average annual return of just 0.4%. However, if you include dividends, the index has actually returned 122% over the same period (or 4% a year), according to Schroders’ calculations.

Headwinds for dividend stocks during the pandemic

Still, there’s a reason the figures presented only go up until 2019. Since the pandemic, this relationship has broken down. The latest data from S&P Global show that, since 1926, dividends have contributed about 31% of the total return for the S&P 500, while capital appreciation has contributed 69%. That’s mostly down to the performance of the past five years.

Since the end of 2021, dividend stocks, as defined by the S&P 500 Dividend Aristocrats index – S&P 500 constituents that have followed a policy of increasing dividends every year for at least 25 consecutive years – have produced a total return of just 9% a year compared with 15.6% for the broader S&P 500 index. This decade, dividends have added just 12% to the S&P 500’s total return, the lowest contribution on record, says Hartford Funds.

As Ian Lance, co-manager at the Redwheel and Temple Bar Investment Trust, notes, equity returns have been “driven by a positive re-rating of equities, particularly in the US and particularly in technology stocks”. Dividend stocks were also hit disproportionately hard in the pandemic years. During 2020, $220 billion of dividends were either cut or paused, according to Janus Henderson.

Research by Goldman Sachs found that more than 80% of US dividend exchange-traded funds (ETFs) underperformed the S&P 500 during the 2020 equity drawdown period, and half of them did not bounce back as strongly as the index in the subsequent recovery.

Dividend stocks also “tend not to perform well when interest rates rise”, as Alan Ray, investment trust research analyst at Kepler Partners, notes. “Investors drawn to conservatively managed dividend-paying companies when interest rates were close to zero now find they can buy ‘risk-free’ UK gilts with yields of 4% or 5%, or even just keep cash in a savings account,” says Ray.

When to trust the dividend yield

Despite the headwinds for dividend stocks over the past five years, history shows they can be a safe haven in periods of volatility and uncertainty. What’s more, many income stocks are now trading at relatively undemanding valuations compared with their growth peers, suggesting there’s a bigger margin of safety with these equities in the event of a market downturn.

There’s no official definition of what makes a good income stock, but there’s one thing most of the research on the topic agrees on, and that’s a correlation between yield and quality, or rather the lack of it. While a dividend stock with a high yield might seem attractive as an income play, more often than not the yield is a reflection of traders’ doubt about the sustainability of the payout.

As Martin Connaghan, co-manager of Murray International Trust, notes, “there is no point in being drawn in by a high dividend yield… because that yield is most likely unsustainable and hence false. Stocks that have, on the face of it, very high yields can be vicious value traps if dividends are subsequently cut.”

In fact, research shows that, rather than chasing high yields, investors should instead look to companies offering yields around the 2% to 4% mark. Yield itself should not be used as a gauge of quality. The best way of evaluating the sustainability and quality of a dividend payout is to analyse the quality of cash flows. In business, cash is king. Cash flow gives a good indication of management’s approach to capital allocation.

As Imran Sattar, portfolio manager of the Edinburgh Investment Trust, notes, “For stocks with higher yields it is important to understand the sustainability of that dividend, how much the dividend is covered by earnings and free cash flow, or ongoing capital generation in the case of a bank… and also to think about whether there is anything on the horizon that could change the cash-flow dynamics such as an increased need for investment.”

This view is echoed by Connaghan, who says, “The ability to sustain and grow dividends is essential. Companies with a high cash-conversion ratio, dividend cover and free cash-flow yield should be in a much stronger position to do this.”

Free cash flow is generally defined as the cash flow generated by operations, excluding the costs of running the business and capital expenditures. In a traditional capital allocation framework, if a firm has free cash to spend, it should first reinvest it back into its operations if it can achieve an attractive and sustainable return on investment. If this opportunity is not available, the company should use the money to reduce debt, and if it has no debt, return the money to investors.

Cash flow figures give us a real, unabridged version of what management is doing with a company’s funds. Investors often turn to earnings before interest, tax, depreciation and amortisation (Ebitda) as a proxy for cash flow, as that’s the metric companies usually like to present. However, this ignores essential business costs, such as the replacement of capital equipment, interest on debt and taxes.

Similarly, a simple dividend cover calculation, which generally takes earnings per share divided by the dividend per share, also provides a misleading picture. Earnings per share do not account for all capital expenditure, particularly on long-term assets, which can be extremely costly for capital-intensive companies. When a company pays a dividend, the money leaves the business. That means the capital must be truly surplus to requirements to prevent problems emerging at a later date.

History is littered with companies that have paid out too much during the good times and have struggled with weak balance sheets and a lack of shareholder support in the bad.

The best dividend stocks

The best dividend stocks are those in companies that strike a balance between operational costs, including capital expenditures, and prudent balance-sheet management, along with sensible dividend policies. And they avoid the damaging concept of a “progressive dividend policy”. Progressive policies envisage the dividend rising steadily year after year. They are designed to provide security for investors. In fact, they do the opposite.

Companies always have and always will go through cycles, and making a commitment to increase a dividend year after year, no matter what, forces management into wrong decisions. It’s difficult to cut a dividend when such a policy is in place, which often puts firms in difficult positions, having to pay out more than they can afford.

Some of the most sensible dividend policies are based on small regular payouts, with annual special dividends based on profit throughout the year. This gives more flexibility, allowing management to announce additional distributions as needed without putting undue stress on the balance sheet. Managers can also choose to alternate between dividends and share buybacks, the latter being easier to turn on and off depending on the business environment.

FTSE 100 insurance giant Admiral is an excellent example. Car insurance can be a volatile and unpredictable business. It moves between a hard market when insurance prices are rising and profits are plentiful and a soft market where competition intensifies, prices fall and insurers have to stomach big losses. Managing a business through this cycle requires financial flexibility and a strong balance sheet, so Admiral cannot afford to commit itself to an unsustainable dividend policy. Instead, it commits to distribute 65% of its post-tax profits annually as a regular dividend, supplementing these distributions with special payouts.

For example, for the first half of the year, Admiral declared a regular dividend of 85.9p per share and a special dividend of 29.1p per share, for a total distribution of 115p, or 88% of post-tax profit. This was a pretty hefty interim distribution for the group. In 2021, a bumper year following the pandemic, which forced a change in driving habits and a substantial reduction in accidents, the company’s annual dividend payout reached just under 280p per share. However, in the following years, as drivers returned to the road and started crashing into each other, the company reduced its distribution in line with falling profits. For the 2023 financial year, it paid out just 103p across both its interim and final dividends.

Another example is CME Group. It pays a regular quarterly dividend, equivalent to a yield of about 2% per year. It supplements this with a special distribution at the end of the year based on annual trading performance. Last year, for example, the company paid out four regular dividends of $1.15 per share and one final special dividend for the year of $5.25.

The perils of a regular dividend policy became all too clear in the mining sector back in 2016. That year, commodity prices slumped as China’s previously meteoric growth started to splutter to a halt, leaving mining giants such as BHP, Rio Tinto, Glencore and Anglo American in a difficult position. Not only had these companies made a commitment to hefty, regular, progressive dividends based on past profitability, they had also spent and borrowed heavily to fund growth.

As commodity prices and revenue plunged, something had to give. BHP cut its interim dividend by 75%, the first cut since 1988, and abandoned its progressive dividend policy. Rio also slashed its dividend in half and Glencore was forced into a messy restructuring involving a $2.5 billion cash call, as well as a dividend cut.

In another example, BT had to cut its dividend in 2020 when management realised the company needed to spend more on its fibre build-out to keep up with the competition. This was a big blow for income investors as prior to the cut BT was often touted as one of the UK market’s top income plays.

Where to hunt for dividend income

Sensible capital allocation is a good indicator of dividend quality, as is the overall quality of the business. Quality can be defined in many different ways. Warren Buffett summed it up quite well in his letter to shareholders of Berkshire Hathaway in 1996: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, 10 and 20 years from now.”

To put it another way, a quality company is one that has a strong competitive advantage and a long runway for growth. A strong competitive advantage also typically translates into higher-than-average profit margins, providing the company with ample cash to invest in marketing, growth and debt repayment, and to return funds to shareholders.

James Harries, co-manager at STS Global Income & Growth Trust, says the best income stocks are “predictable, resilient, high-quality businesses” you can “say something sensible about on a five-,seven- and 10-year view”. That often means sticking with the companies that he describes as “steady as she goes” – they often “grow slower, but [grow] more persistently”.

A great example of the strategy, and a recent addition to the portfolio, is Nike. “It’s the highest quality global sports brand,” notes Harries, and though the company is going through some turbulence, “I’m pretty confident that we’re buying a really high-quality asset at a very attractive valuation”. Nike is one of the best-known and valuable consumer brands in the world, boasts a gross profit margin of more than 40%, and has billions of dollars in net cash on the balance sheet. It’s also rewarding shareholders, with $591 million in dividends in the first half of 2026 and $18 billion returned via share buybacks since June 2022.

The utilities sector can also be a good place to hunt for income. “Often a utility company operates in a regulated sector that is supported by a long-term concession contract, which will stipulate the return that can be generated over the life of the concession,” notes Jacqueline Broers, co-portfolio manager at Utilico Emerging Markets. As a result, cash flows can be more “resilient” and “predictable” than those of other sectors. “All of which translates into a more sustainable long-term dividend payout.”

Broers highlights the example of IndiGrid Infrastructure Trust, which owns 41 power projects comprising 17 operational transmission projects, three greenfield transmission projects, 19 solar generation projects, and battery energy storage (BESS) projects located across 20 states and two union territories in India. The average remaining contract life on the company’s transmission assets is just under 26 years, with contracted revenues underpinning the company’s dividend yield of about 10%.

The other advantage utilities tend to have is the prohibitive replacement cost of their assets. Take UK-based National Grid, which owns the majority of the UK’s high-voltage transmission network, comprising thousands of miles of cables and transmission stations. Building these assets from the ground up would be virtually impossible today, not to mention the vast cost. That gives the company a robust competitive advantage.

Utilities aren’t the only companies that can have such an edge. Connaghan points to the likes of Grupo ASUR, a Mexican-listed airport operator with 16 assets across Central and Latin America. “Its key asset is Cancun airport and the company has seen its passenger numbers increase by a compound annual growth rate of 6% over the last 35 years,” he says. “Such was the financial strength of this business in the earlier part of this year that in April, they announced two 15-peso special dividends in addition to a regular dividend of 50 pesos. This put the stock on a 14% dividend yield.”

The fund manager also highlights the likes of Enbridge, a Canadian pipeline business which transports and stores natural gas and oil through its network, which spans North America. The company has grown its dividend for 30 years in a row. “This type of business is far less exposed to the underlying shifts in the commodity prices themselves, as 98% of its Ebitda comes from assets backed by either regulated returns or take or pay agreements,” he notes.

Investment trusts for dividend income

The structure of an investment trust lends itself to income investing. Not only do they give investors access to a well-diversified portfolio of income stocks, but they can also pay dividends out of both capital and income, unlike ETFs and other open-ended investments. That means trusts are more likely to be able to sustain their dividends in periods of market volatility. Trusts with a global mandate also have far more flexibility in where they can invest so they can pick the best income, quality and growth plays in the world.

JP Morgan Global Growth and Income (LSE: JGGI), Murray International (LSE: MYI), Scottish American (LSE: SAIN) and STS Global Income & Growth (LSE: STS) all have a global mandate. Ecofin Global Utilities and Infrastructure (LSE: EGL) has a global mandate within its utility sector. Others, such as Law Debenture (LSE: LWDB) and Temple Bar (LSE: TMPL), have a UK focus, but with some international holdings.

This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.