Business

Why dividends matter

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IN these turbulent market times, there has been a lot of attention on dividends paid out by companies, and a number of high-profile FTSE 100 companies have cut their dividends in recent weeks.

The UK market has traditionally seen a higher yield than many of its global counterparts and the reliance on dividend income by a wide range of investors, from individuals to pension funds, has become more apparent in these times of consistently low interest rates.

Apart from their obvious use for investors seeking income, dividends provide a good indication of the financial well-being of a company. Whilst creative accounting can be used to manipulate accounts, dividends are hard cash and companies that pay out dividends are usually disciplined and efficient in capital allocation and cash management.

Dividends are, of course, a vital part of total return – over the course of 10 years in the UK market (as measured by the FTSE 100) total annualised return was 4.3 per cent but rose to 8.3 per cent when dividends were included.

The relative importance of dividends as a proportion of total return increases over time and strongly suggests that to maximise total return over the long term, the best strategy is to reinvest dividends.

As noted above, dividends can be a good measure of financial health and this is borne out by research showing that over the long-term dividend payers tend to outperform the market.

In times of low growth, the importance of dividends increases, in times of slow economic growth, rising inflation and rising unemployment such as in the 1940s, dividends accounted for over 75 per cent of total returns.

In addition, dividends are less volatile than earnings thus providing a cushion for investors and over the long term they can also provide a useful hedge against inflation as dividend income tends to grow in line with or in excess of the level of inflation.

Over the past couple of months in the UK market we have seen unprecedented levels of dividend cuts which puts pressure on, for example, equity income funds.

However, investment trusts have revenue reserves which means they can potentially maintain or increase distributions even in times of dividend cuts. They have the ability to reserve up to 15 per cent of net revenues each year which can be used in less favourable times. Such funds also have the advantage of investing in a wide range of dividend paying companies thus spreading the risk.

Clearly there are no guarantees in equity investment, and shares are regarded as being higher up the risk spectrum, but dividend cuts have not been universal and in these low inflation/low interest rate times good returns can be hard to come by.

With interest rates standing at record lows (base rate is 0.1 per cent) the yield on the FTSE 100 is around 4 per cent. However, the worrying fact is that a relatively modest number of stocks account for a high proportion of the market yield. So far 32 out of 100 companies in the FTSE 100 have announced a cut, suspension or deferment of their dividend payment.

:: Cathy Dixon is a partner at the Belfast office of Cunningham Coates Stockbrokers. This article does not constitute a recommendation to buy or sell investments and the value of any shares may fall as well as rise.