If you want to make money out of stocks in the long run, a healthy stream of dividend income is vital.
In the UK, it’s always been possible to find stocks that pay decent dividends. We’ve been tipping many of them recently.
In the US, it’s a different story. By our standards, American companies are surprisingly stingy with their dividends.
But this could be about to change. US companies are going to come under growing pressure to raise their pay-outs.
That means you should be keeping an eye on stocks that have the capacity to pay out more to shareholders – they could end up being very profitable investments in the long run…
Dividends are vital to long-term returns
You could be forgiven for feeling disillusioned with the stock market right now. Buying shares seems to have become as big a gamble as punting at your local casino.
But the fact remains that over time, putting money in the stock market really has paid off, according to the annual Barclays Capital Equity Gilt Study. The key factor has not been capital growth. It’s been what you actually get from holding a share: the dividend.
Say $100 had been invested at the end of 1925 in US shares. By the start of this year, in actual money, it would have risen in value to $9,524. In real terms – ie adjusted for the cost of living – that $100 would have been worth $778. In other words, an investor in 1925 would have beaten inflation by a massive margin. Not bad at all.
But look what happens when the dividends received are reinvested. That same $100 back in 1925 would have turned into a stunning $301,850. Allowing for inflation, the return would still have been $24,733. That’s quite spectacular.
So why do most people in the investment business complain that you can’t get good dividends from US stocks? Because, while US dividends haven’t always been poor, for the last 15 years the average yield on US stocks has been just 1.8%.
Indeed, right now, dividend payouts as a percentage of the profits made by American companies are at a three-year low. Over the last 30 years, an average of 41% of US earnings was paid out as dividends, according to Wells Fargo & Co. Yet in 2011’s second quarter, firms in the S&P 500 index paid out just 27% of their profits in dividends.
Companies are stockpiling cash, because they know they can’t rely on banks to be in any condition to lend. In the three months to the end of June, US companies increased their cash, cash equivalents and short-term money market securities by 63% to a record $2.77trn, according to Bloomberg data.
But these cash piles might now be as high as they’re likely to get. Why?
Big shareholders are getting sick of low yields
Low dividend yields weren’t a problem for investors when the US stock market was soaring as it did in the late-1990s. But now that capital returns from just holding shares have become much more volatile, dividend payouts have begun to matter much more to investors.
So now big shareholders in a number of wealthy US companies are starting to demand their share. As Wells Fargo’s Martin Adams says, “they want some form of yield off their equity investments”.
And it’s not just institutions. Peter Vanderlee of ClearBridge Advisors (a subsidiary of Legg Mason) notes that “around 76 million baby boomers [are] about to retire and are doing so with insufficient savings”. They’re keen to get “inflation protection in their retirement”, so they’ll be looking for companies to hike their dividends to stay ahead of price rises.
Meanwhile, the companies themselves are now getting such a low interest rate on the money they’re stockpiling, that it makes more sense for them to use their cash piles to keep their shareholders happy.
Sure, there may a snag for private investors. Some American firms could spend their money mountains on share buybacks. While these generally boost stock prices, they tend to benefit the major institutions more than smaller players, as my colleague Tim Bennett points out.
And let’s be clear here. For now, we’re wary of the US market overall. The country is heading for recession again, as John Stepek noted last week. That’s likely to mean most share prices will have further to fall.
But a sea change in dividend policy would be a long–term positive signal for some US equities. For investors who’ve shunned these due to their lack of yield, higher payouts could prove a turning point. It could re-ignite their interest in stocks they’ve avoided before.
We’ll keep you abreast of developments. But here are two names to add to your watch list. Net cash at computer firm Dell (Nasdaq: DELL) is around a third of the firm’s market cap. There’s no dividend right now, but on a p/e ratio of below eight, Dell can clearly afford to start rewarding its shareholders properly.
Meanwhile Microsoft (Nasdaq: MSFT), on a p/e of nine, currently pays a 2.5% yield, but with over $40bn of cash in the bank, it would easily be able to increase its dividend payout far more. Watch this space.
And if you like the idea of building a portfolio of of high dividend paying shares here in the UK, do take a look at The Dividend Letter. It’s written by my colleague Stephen Bland, and the aim is to provide you with a growing income for life. You can find out more here.
Category: Economics