Hanging onto the family silver: Investment strategy

By Neville Bennett

Friday 12th November 2004

Most investors recognise that equities are important for the long-term growth of their assets. It is also true that a well-chosen equity portfolio will appreciate in capital value in time. But investors commonly overlook the value of dividends in asset growth.

The long-run return on equities is sometimes exaggerated because the evidence cited is the appreciation of an index. This has some validity when investors buy the index in an index fund. But it is off the mark to assume indexes reflect accurately the market.

The point is easily made. Stock indexes are often to the top 10, top 30 or whatever. It is a basket of winners or high achievers. At regular intervals the index is adjusted to admit champions from below and relegate poor performers. Someone who bought "share of the year" Enron would be a little wary of judging stock performance by indices.

There are several strategies underlying equity investments. The most common idea is capital appreciation. Indeed American investors seem to think of little else. Capital gains often arise from businesses that seem likely to grasp new opportunities. This idea drove the tech bubble in the Nasdaq before 2000. The idea persists in new technology and biotech but can also apply to older industries that appear to have great prospects such as oil finds.

Investors are cheered by the idea that a business will create a niche, expand market share or enjoy a near monopoly that will eventually lead to sharp capital gains. By way of illustration, I have had a flutter on NZOG, Cadmus and Botrizen. None pays a dividend but they have the potential to do so.

"Value" investments are a different strategy. The investor buys shares that seem undervalued and capable of paying a steady stream of dividends. In its simplest operation, this is merely a way of putting money to work in the short term. Big funds study the stock-bond ratio. They tend to move money into stocks out of fixed-interest when the interest rate is low. When interest rates rise, the flow reverses somewhat. At present the stock-bond ratio is declining somewhat sluggishly as equities also thrive in times of good economic growth.

The real merits of value investing emerge over time. This should not be a startling revelation as it is fundamental to the philosophy of Warren Buffet's Berkshire fund.

Again by way of illustration, about 15 years ago my family bought a parcel of Hallensteins at 50c. They have increased in capital value seven times. Equally importantly, the dividend yield is now about 40% on the original capital.

Some shares are like the family silver: they are not for sale. They perform year after year and the trend is to reward shareholders with rising dividends.

The point cannot be over-emphasised. Many investors focus too much on price appreciation and tend to undervalue the contribution of dividends. The fact is that the longer the time horizon, the more important dividends are in generating total equity returns. The reason? Compound interest.

The chart shows over the past 30 years reinvested dividends have provided a larger proportion of world stock market returns than price appreciation.

Stock prices have risen by a factor of almost 10 since 1973 but when dividends are reinvested total returns have increased by some 24 times.

There are great opportunities for a value strategy in New Zealand. The availability of imputation credits greatly increase gross yield. There is also a culture of rewarding shareholders with a high proportion of profits. Moreover, there are many excellent businesses in agriculture, energy and retail that continue to be profitable.

How many stocks provide a reliable and rising dividend income stream? Apparently there are relatively few elsewhere. In the US about 12,000 stocks are traded but only 156 have raised dividends significantly (10%) every year for the past 10 years.

A new fund, Eastern Point Advisors Rising Dividend, has collected these "dividend dazzlers." It includes Bank of America, BP, Caterpillar, General Electric, Johnson & Johnson, Microsoft and Pfizer. It seems remarkable these giants can generate rising wealth for shareholders.

These companies are dazzlers because the average Wall Street yield is only 1.7%. The trend is up, however, since the 2003 tax cuts brought dividends back into style. In 2002, only 351 of the S&P 500 paid dividends; it has now reached 376 and to date this year 226 have announced increased dividends.

The evidence indicates a buy and hold strategy for value shares can be an important part of an investment portfolio. It returns a good yield and appreciating capital values are a good defence against short-term corrections. Every portfolio should have some family silver.

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