“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” – John D. Rockefeller
A discussion of dividends or income can lead to glazed eyes of some equity market participants. Hot-handed momentum traders care only for the greater fool who will pay a higher price for their slice of equity. Long-term growth investors may well be invested in companies at the pre-profitability stage and hence dividends are not on the agenda. Alternatively, some investors believe in the capital allocation credentials of their management teams to the extent they entrust management to reallocate all profits on their behalf.
Meanwhile, the income investor knows exactly when his or her companies go ex-dividend, and feels Rockefeller’s embrace when the pay date comes and the dividend shows up on the daily cash sheet.
In truth, an interest in dividends is a hall mark of the equity investor. Equity is nothing more than the sliver of hope that separates assets from liabilities. The owner of common equity is entitled to nothing other than any dividend that might be declared by the board of directors.
Of course, the knowledge that dividends are important is no guarantee of success. The greatest risk is being blinded by the light emanating from a company with an exceptionally high current yield (most recent 12 month dividend divided by current price). This light should be treated as emanating from a light-house. Purchasing these equities can be a perilous exercise akin to an attempt to shortcut a headland by sailing over skerry infested waters. Dividend cuts can sink a portfolio.
It is not the yield at time of purchase that dictates the success of an equity investment, rather, the growth of that dividend over the holding period. To demonstrate this, the chart below shows the development of portfolio valuation from four different dividend growth scenarios:
Source: Cerno Capital
In each case, the starting yield on the portfolio is 3%. We have assumed dividends are reinvested and taken the analysis out for twenty years. We have also assumed no valuation change in the pricing of the investments. The message is very clear: if an investor has a long time horizon, for example, someone in their forties looking to make investments that will provide income beyond retirement, the rate of dividend growth is the key determinant of investment success. The growth in dividends (the G in D from our title) will substantially account for the price appreciation of the asset.
To emphasise this point, an investor in a no dividend growth portfolio might receive £5.41 in year twenty. Meanwhile, an investor in a 10% dividend growth portfolio will receive a dividend cheque of £103 in year twenty.
If we give the zero dividend growth portfolio a head start of an initial yield of 5% and assume the dividend survives, the 10% dividend growth portfolio has overtaken the no dividend growth portfolio by year ten and by year twenty is producing seven times the dividends of the former.
At this juncture, it is tempting to suggest a strategy which looks for those companies that have high historic dividend growth rates. Such a strategy has some merit. However, it would be backward looking and would completely miss the point that high dividend growth is the product of a successful business that is run by management which acknowledges the interests of shareholders. Growing dividends can only be produced by companies which generate cash rather than paper profits and which have a dominant industry position that allows them to maintain their profit margins over a prolonged period of time.
These are the types of companies targeted by the Cerno Global Leaders Strategy. Our selection criteria are tightly defined and forward looking. The level of dividend or its history is not one of our criteria. However, the companies we own today have an average five year dividend growth rate of 11.3%. Our intention is to hold these companies for a very long time.
We look forward to counting our dividends.
For further information about the Cerno Global Leaders, invested as part of our core investment strategy, please refer to the TM Cerno Select Fund webpage.