QUALIPORT
Dividends v Gilts: FTSE 6,253?

By Maynard Paton (TMFMayn)
May 8, 2003

The FTSE 100 at 4,000 offers an attractive dividend yield when compared to government bonds (gilts). If the market traded in line with the post-1959 relationship between gilts and equity dividends, the blue chip index would now stand at 6,253.

Why a post-1959 relationship? Simply, August 27th, 1959 proved to be a turning point for investors. It was the day when the stock market first offered a dividend yield lower than the income available from gilts. Ever since, investors have acknowledged the 'reverse yield gap'; that is, they've accepted a lower yield on shares with the expectation that dividends will grow over time and overtake the (fixed) income from gilts.

Good old days

The 1950s proved to be a decade when 'this time it was different' and investors did in fact enter a new valuation paradigm. Gradually, shares shrugged off their 'risky' nature as investors came to terms with economic prosperity, dividend growth and the impact of inflation. John Littlewood's marvellous book The Stock Market: 50 Years Of Capitalism At Work provides some background to the investment era of fifty years ago:

"An entirely new and decisive factor for equity investment had appeared in 1953 -- in the name of Charles Clore. In January, Clore made a successful bid for the shoe chain J Sears & Co. He bid 40/- for 2.25m shares and, in doing so, drew attention to the underlying value hiding behind the share prices of quoted companies. His bid for Sears was a catalyst for change in both the complacent attitude of company directors towards their shareholders, and in the passive and undemanding attitude of shareholders towards their investments."

"Although dividend restraint had made it genuinely difficult for companies to increase dividends in line with earnings, these restrictions suited the instinctive conservatism of many boards of directors. Until National Provincial Bank took the lead in 1953, the dividends of the clearing banks had been unchanged for 21 years. The low valuation of equity shares in the 1950s was a consequence of the liking of directors for a cushion of earnings and assets, and the tendency of investors to value shares almost exclusively by reference to dividend yield. The extent of dividend cover was largely ignored, as was the fact that share prices frequently stood well below asset value in the balance sheet"

"Glaxo Laboratories was a growth stock by the standards of the 1950s and its shares yielded 3.85%. The dividend was covered nearly 12 times by earnings to give an earnings yield of 45%, or a P/E ratio of just over 2."

The relaxation of various corporate controls and the rise of the institutional investor all helped to form the so-called 'cult of the equity'. The seismic shift in valuation that occurred during the 1950s, led amongst others by George Ross Goobey of the Imperial Tobacco (LSE: IMT)(NYSE: ITY) pension fund, is highlighted in the table below. Using data from Bloomberg and the Credit Suisse First Boston 2003 Equity Gilt study, the table shows how the relationship between gilts and dividends changed after 1959.

Period       Gilt      Dividend     Gilt/   
             Yield      Yield      Dividend
              (%)        (%)         (x)

1919-1938     4.1        5.5         0.75
1949-1958     4.2        5.3         0.79
1959-1978     8.8        5.0         1.76
1979-1999     9.7        4.5         2.16
2000-2002     4.9        2.6         1.88

1919-2002     6.5        4.9         1.33
1959-2002     9.0        4.6         1.96

Present day

At present, the FTSE 100 at 4,000 offers a 3.49% dividend yield while 10-year gilts currently offer income of 4.36%. The gilt/dividend ratio is thus 1.25, slightly below the 1919-2002 average of 1.33. If the price of gilts were to remain the same, the FTSE 100 would need to rise to 4,243 to match the 84-year trend.

However, if you believe gilts will forever yield more than equities (aside from the odd blip), then it's worth concentrating on the post-1959 data. Between 1959 and 2002 then, the gilt/dividend ratio has averaged 1.96. With gilts at 4.36%, the market should be yielding 2.22%, i.e. the FTSE 100 ought to be 6,253. So does the market have 50% immediate upside? Not exactly.

The next table reveals the performance of dividend payments over the past few years. It shows FTSE 100 investors watching their payouts (as measured by FTSE 100 index points) decline since the end of 1999:

Year-end       FTSE 100    Yield     FTSE 100 dividend
                            (%)       index points

1999            6930.2      2.04         141.38
2000            6222.5      2.18         135.65
2001            5217.4      2.59         135.13
2002            3940.4      3.55         139.88

Given the lacklustre dividend performance of late, it's no surprise to see the market's yield languishing. Over time though, the global economy grows, corporate profits increase and so too do dividends. There have been a few high-profile dividend cuts recently, but anecdotal evidence suggests most payouts are holding up well.

In the future, the FTSE 100 should witness a 'double whammy' re-rating, it benefiting from a recovery in dividend growth and the prospect of a lower dividend yield. For instance, if over the next five years...

• blue chip dividends grew by 3% per annum;
• the income from gilts increased to 5%, and;
• the gilt/dividend yield ratio rose to 1.6 (some way below the post-1959 average of 1.96).

...the FTSE 100 could see 5,172 in 2008. Add on the current 3.49% dividend yield, and a medium-term annual return of nearly 9% can be expected. Of course, there's always the danger of 'fighting the last war' when looking back at past stock market statistics. Furthermore, projecting future dividend growth and gilt yields is little more than educated guesswork. However, unless we're in for a rerun of 1970s stagflation(whereby corporate profits slump as inflation/gilt yields take off), it's very difficult to make a case for equities being anything other than cheap when set against gilts.