In this edition of Technical Update we look at what makes a good income investment and how Financial Planners can maximise returns in a difficult climate. Problems in the Eurozone mean typically favoured investments, such as gilts, have fallen to their lowest ever level and are no longer seen as viable ‘safe haven’ investments. As a result, Financial Planners are looking outside the box for alternative means of investment to find growth potential.

Experienced fund manager Stuart Rhodes of M&G believes that he has a potential answer in the form of dividend investing and dividend-paying shares which he believes have under-realised values for funds.

In this article Mr Rhodes will examine the different approaches to dividend investing and how the compounding effect of dividend growth can help build value.

He will focus on the challenges involved in this form of investing such as the unexpected problems of high dividend yield, the importance of having a balanced portfolio and the factors to consider when picking a good investment. Through his experiences with the M&G Global Dividend Fund, Mr Rhodes will also share his insight into why investors should not limit their investments to the UK market.

In past years, investors could hope to generate an adequate income by simply putting money into a savings account, but with interest rates now so low, many people are seeking to achieve their goals by investing; whether for retirement, paying off the mortgage or saving for children’s education.

However, it has also become increasingly difficult to earn a decent income from most asset classes. Take, for example, government bonds: the income earned from gilts has recently fallen to its lowest ever level, pushed down by investors looking for ‘safe-haven’ investments, having become increasingly fearful over the eurozone debt crisis.

Dividend-paying shares present one possible solution to this problem. In fact, it has been a bumper time for dividend investors in the UK. British companies handed shareholders nearly £68 billion last year, a 19.4 per cent increase on 2010, according to Capita Registrars. The figures were flattered by one-off factors such as BP resuming payments following the oil spill in the Gulf of Mexico and special dividends from the likes of International Power, but the underlying growth rate of 12.8 per cent was nonetheless impressive. This year could also see another vintage crop, with Capita forecasting an annual rise of 11 per cent in dividends.

Dividends can help build wealth

It is no secret that the bulk of investment returns over time is generated by the reinvestment of dividends. The chart below demonstrates this by showing that, over the past 10 years, US companies with a consistent record of increasing their dividend payments deliver better share-price performance, or capital return, than the broader equity market. What is more, investors also receive the income from the rising dividend stream, thereby increasing their overall total return. Much of this is down to the power of compound interest, with growth working on a larger sum each year and hence becoming magnified.

In order to derive even more power from the effect of compounding, you could invest in companies that steadily increase their dividend payouts over long periods of time. Not only would this boost the growth of your investment, but higher dividends put upward pressure on the share prices of companies that increase their dividends. This is demonstrated by an elite group of companies from the US that can boast uninterrupted dividend growth for at least 25 years. As shown on the chart, these ‘dividend achievers’ have generated a significantly higher total return over 10 years than the stockmarket as a whole. This record of returns does not just hold true in the US. In general, companies, wherever they are in the world, that can grow their dividends over time enjoy superior performance.

Different approach to dividends

My approach to dividend investing differs from that of most traditional income fund managers in that I prefer to concentrate on companies that can consistently grow their dividends, rather than those that simply offer a high yield. Businesses that are able to increase their dividends year after year must be growing in a disciplined manner since dividends regulate the amount of capital available for expansion, ensuring that only the most profitable projects are undertaken. Thus, I benefit from investing in well-run companies as well as from the powerful effect of compounding.

In my opinion, a company providing a reasonable yield but which can steadily increase its dividend over time is, in general, a more worthwhile investment than a company with a higher, but static yield. The chart overleaf  (Not Shown) shows just how steady growth over time boosts the dividends received; thereby increasing the holder’s income. What is more, it is very likely that a company that has been able to grow its dividend each year would also have enjoyed substantial share price appreciation.

High yield can mean distress

Traditionally, dividend investors focus on the dividend yield offered by the shares. However, focusing on high dividend yield can be a flawed approach, as a high yield often signals that a company is in trouble or has limited growth prospects. Picking good investments from among such companies is an extremely difficult and risky strategy. Furthermore, higher yielding stocks tend to be ‘defensive’ and, while they may hold up well when equity prices are weak, simply concentrating on this area of the market can leave a portfolio vulnerable to underperformance when investor sentiment improves.
When identifying potential investments I prefer to look for companies that are in the position to increase their dividend in a sustainable manner over the long term. In my opinion, dividends provide the ultimate indication of a firm’s financial self-control and commitment to shareholder value. A business cannot support a rising dividend stream without sensible long-term growth in its operations.

The importance of having a balance

The natural hunting ground for companies offering consistent dividend growth is among high quality stocks – large multinationals with strong market positions and steady cashflow that enables them to increase their dividends year after year. However, since these ‘defensive’ companies can fall behind when investors become more positive, I also invest in economically sensitive businesses.

In order to counteract the traditional defensive bias of equity income strategies, whereby a portfolio typically consists of low risk/low return investments, I try to construct a balanced portfolio that can also perform well when markets are driven by an improving economic outlook. I select companies with long-term dividend growth potential from three different sources of dividends. The core of the fund is made up of high-quality, defensive multinationals, such as Johnson & Johnson, which should be able to deliver consistent dividend growth. However, I also invest in asset- backed companies with good capital discipline in industries that do well in an improving economic environment. Additionally, I invest in rapid-growth companies that are experiencing high growth in revenue that can be translated into growing dividends. Having different sources of dividends with the common characteristic of strong capital discipline should help performance in a variety of different markets.

A world of income opportunities

In order to reap the greatest benefit from dividend investing, I believe strongly that investors should search globally for opportunities instead of simply focusing on the domestic market. The UK is a highly concentrated market and the lion’s share of dividends is paid by just a handful of large companies. By searching for dividend opportunities on a global basis I believe investors benefit from flexibility of choice and valuable diversification. There are many companies in different sectors worldwide that raise and use their capital wisely and that have been able to demonstrate this excellent capital discipline through dividend increases year after year.

We aim to identify companies that are most committed to rewarding their shareholders by steadily increasing dividends whatever the market background. Unfortunately, many companies are all too ready to cut the payout during difficult times. In particular, UK companies with a very long history of dividend growth are few and far between. In the US, there are around 90 companies which have raised their payouts to shareholders every year for at least a quarter of a century. Some, like Johnson & Johnson, manufacturer of baby shampoo and mouthwash, have done so for almost 50 years. Our own research has identified fewer than 10 companies listed on the London Stock Exchange with track records that match the ‘dividend achievers’ in the US. Tesco and Greggs are members of a rare breed.

Although the US market might offer the widest range of outstanding dividend-paying companies, Europe is also home to plenty of firms, such as Nestle and Roche, with good capital discipline and the potential for long-term dividend growth. Further afield, we have identified attractive dividend opportunities in Australia, Brazil and Taiwan. Australia has an established dividend culture spanning several decades, while laws in Brazil require companies there to distribute at least 25 per cent of net profits to shareholders*. In both countries there are companies with excellent management teams, as well as good growth prospects. Meanwhile, Taiwan offers a range of dividend-paying technology companies, an industry well known for reinvesting cashflow within the business. Japan, on the other hand, has traditionally offered meagre pickings for dividend investors.

Picking good investments

It is also important to pick stocks on their individual merits rather than being influenced by economics. I focus on company fundamentals, searching for well-managed businesses that understand shareholder value and with efficient capital allocation; enabling them to grow their dividend in a sustainable manner over time. Only when I am satisfied that the company has the potential to grow its dividend do I see whether it can be bought on a sufficiently attractive yield. As well-managed companies with good financial discipline can be expensive, I pay close attention to valuation – I want good investments, not just good companies.

Opportunities for long-term investors

The recent turmoil in stockmarkets reflects issues such as government debt problems and slowing economic growth that do not have immediate solutions. However, indiscriminate selling in such an environment creates opportunities for stockpickers with a long-term horizon. I am encouraged that, despite the difficult economic times, many companies continue to deliver healthy dividend increases. For example, 20 of the holdings in the M&G Global Dividend Fund announced dividend increases in the first two months of 2012, including a 35 per cent rise from US toymaker Mattel and a 25 per cent boost by Umicore, a Belgian precious metal recycler. This reinforces my confidence that a consistent approach to dividend investing, concentrating on how companies are run, will reward patient investors over time.