FOOL'S EYE VIEW
Why Dividends Are Important

By Rob Davies
March 22, 2001

Carburton Street, London -- In the last few years most investors have focused on capital growth rather than on dividend income, and that was certainly a winning strategy for most of the nineties. However, going into the noughties it seems there has been somewhat of a change in sentiment. We can see that from the sectors appearing in the list of the top ten best performers in the last year. It includes such mundane businesses as Tobacco, Household Goods and Water utilities. A unifying factor for all of them is that these are sectors with higher dividend yields than the market average. If we are fairly sure that the dividend payment can be maintained then we can be pretty confident of getting a good return for the company on the dividend alone, even if there is little or no capital growth.

Quite a few companies now offer dividend yields in excess of the interest rates available on deposit accounts and, with the prospect of further interest rate cuts, those returns look even more enticing. Moreover, there is every chance that dividends will be progressively increased in the future, further enhancing the attraction of high yield equities over deposit accounts.

While high yield shares always have had their fans we should not lose sight of the role that dividends have played across the market as a whole. That might seem surprising. After all, even with its recent falls the FT All-Share index still only has a yield of 2.9%, not much in the overall scheme of things. But one staggering fact from the definitive CSFB Equity-Gilt review last year shows how important dividends really are.

Over half the total return comes from dividends

Over the last 80 years the average annual return from capital growth alone in UK equities has been 3.1%. But add in dividends each year and the return more than doubles to 8.2%. That is amazing. It means that more than half the total return comes from dividends. Now they suddenly seem a lot more important, don't they?

Dead right they are. Dividends are the tangible evidence that the company you have invested in is actually getting in more cash from its business than it is spending. That may not always be after capital investment in any individual year but, over time, that expenditure should earn a return that can be defined in cash. Paying out dividends is a good discipline for companies because it forces them to focus on activities that make real returns that people pay hard cash for. Any company that says it is doing well, but not paying out decent dividends, needs to have a very good reason for not doing so.

Dividends must be re-invested

It is of course very tempting for the investor to take this cash payout and spend it. But the lesson from history is that if you do that you suffer poor returns. It is vitally important that the dividends are re-invested back into the fund so that the magic of compound interest can do its work. The money does not necessarily have to go back into the same company -- maybe another one offers better prospects -- but as long as it stays in the market it is working for you. Using cash from dividends to buy more shares gives the investor a bigger exposure to the market, and hence ultimately more dividend income. That in turn can then be re-invested and so the process goes on.

It is this slow, but virtually inexorable process that gradually accretes wealth to the long-term investor. It is not really discernible over a period of few months, or even a year or so. But let it gently simmer for a decade or two and the returns become quite dramatic. That is why investing in the stock market is all about long-term buy and hold.

More: Fool's Guide to Dividends