As all good Foolish investors should know, the compounding effect of reinvesting dividends is the secret sauce of long-term stock market returns. For example, the latest annual Barclays Equity Gilt study shows that £100 invested in UK shares in 1945 would now be worth £9,347 if dividends had been taken as cash — but £177,620 if they had been reinvested to buy more shares instead.
But does this mean we should avoid companies — such as Royal Bank of Scotland (LSE: RBS) (NYSE: RBS.US), International Consolidated Airlines (LSE: IAG) and AA (LSE: AA) — that are not currently paying dividends?
Royal Bank of Scotland
The shares of Royal Bank of Scotland’s rival Lloyds have gained 15% since the start of the year. The market has warmed to Lloyds’ bright earnings and dividend prospects, with the company announcing a first dividend in six years in February and strong Q1 results in May.
In contrast, RBS’s shares have drifted down 7% since the start of the year. Of course, RBS is behind Lloyds in its rehabilitation from the financial crisis and has yet to resume dividends. But could the Edinburgh-headquartered bank be worth buying now in anticipation of the same kind of improving sentiment Lloyds is currently enjoying?
Some analysts had expected Lloyds to restart dividends a year earlier than it did, and the Black Horse’s shares then trotted on the spot for another barren year. Even when the resumption of dividends was finally announced, you could still buy the shares at around the same level as a year earlier (and over 10% below the current price). As such, I don’t believe there’s any big hurry to buy into RBS before it announces the restart of dividends — which may or may not be with the company’s 2015 results next February.
International Consolidated Airlines
Formed in January 2011 by the merger of British Airways and Spanish flag carrier Iberia, International Consolidated Airlines (IAG) has never paid a dividend. However, the company signalled at the back-end of last year that it was confident of meeting its 2015 financial targets “which we see as the trigger to introducing a dividend”.
IAG’s €1.4bn bid for Aer Lingus, announced in May, had some commentators worried about the dividend, but chairman Antonio Vazquez reassured shareholders at the company’s recent AGM: “We anticipate … that we will announce a dividend before year-end, based on a payout ratio of 25% of underlying profit after tax”.
Analysts are expecting IAG to deliver earnings of about 52p a share for 2015, which at a 25% payout ratio would give a dividend of 13p, and a 2.5% yield. That’s a nice bonus for investors in a company which is currently trading on a bargain rating of less than 10 times forecast 2015 earnings, following analyst upgrades over the past six months.
The AA, which was floated on the stock market a year or so ago, is the largest roadside assistance provider in the UK with over 40% of the market. The self-styled “fourth emergency service” is highly cash generative, and requires only low maintenance capex and negligible working capital investment. Because of these hugely attractive qualities, I think the AA merits its premium rating of 17 times current-year forecast earnings.
Unfortunately, when the company came to market it had a lot of debt on its balance sheet (thanks to its previous private equity owners). Management was intent on retaining earnings to reduce leverage by repaying outstanding debt, meaning there was no immediate prospect of dividends.
However, a subsequent equity placing and refinancing have enabled the Board to commit to a dividend of “no less than £50m” this year, and to adopt a progressive dividend policy. £50m implies 8.25p a share, but City analysts are forecasting 9.25p, giving a yield of 2.5%. With strong cash generation from predictable repeat business, and continued deleveraging, the AA looks a great candidate for investors to build their wealth by reinvesting a growing stream of dividends.
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G A Chester has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.