By Scott Francis

April 30, 2012

PORTFOLIO POINT: A key attraction of shares is their ability to outperform inflation through dividend growth, both in the medium and long term.

Warren Buffett talked about ‘forever’ as being his favourite holding period for a sharemarket investment. While this seems problematic for investors who are retired and living on their investment portfolio (unless, of course, you are like Buffett and measure your net wealth in billions of dollars), in Australia we have a tax regime that encourages companies to pay part of their earnings to investors in the form of dividends. The tax benefit of franking credits means that an investor on an average tax rate pays almost no tax from receiving a dividend, and a person in retirement using a superannuation fund to pay them a pension will actually receive a tax refund equal to the value of the franking credits. This is more attractive than a company retaining earnings (rather than paying them as dividends), and investing in new projects that lead to taxable capital gains in share price.

With the tax effectiveness of dividends, and with the Australian market providing an average yield of 4% to 5%, suddenly ‘forever’ becomes a feasible holding period, even for investors in retirement – keep the shares, spend the dividends, send a thank-you note to the ATO for the refund of franking credits, and life is good.

A big – and growing – issue in retirement is inflation. As we live further into our 80s and 90s, our investments have to support us for longer. I was recently looking for a birthday card in my local newsagent, and noticed that they now stock a choice of two cards for people passing on 100th birthday wishes; our portfolios have to be positioned to cope with this.

As an example, a person retiring with $1,000,000 today might be happy to put this in the bank and earn 5.5% interest on this money, providing them with an income of $55,000. Their problem is that over a 30-year period, assuming inflation of 4% a year, their $55,000 will end up purchasing the equivalent of only $17,000 of today’s goods and services.

Which brings us back to dividends – and more specifically, to the question of how well dividends have served investors over the past 10 years. To do this, I started with the 10 biggest companies in the market – not unreasonably thinking that these (generally big miners and big banks) would have been widely held by investors. I looked at dividends at three points in time:

- Their dividends in the 2002/03 financial year (five years prior to the pre-GFC market peak)

- Their dividends in the 2007/08 financial year (the pre-GFC market peak)

- Their most recent 12 months of dividends

The following table assumes that an investor held a portfolio of shares that provided $1,000 worth of dividends in each company in the 2002/03 financial year. It then tracks the increase/decrease in dividends:

Table: Change in dividends in ASX-listed top 10 largest companies over 10 years

In the five-year period starting in the financial year ended June 2003, the increase in dividends was 73%. Using the RBA calculator here, inflation over that period was 16.5%. Clearly, the growth in dividends outstripped inflation.

The results from the period that includes the GFC are also interesting. Over the GFC period (pre-GFC peak in the financial year ended 2008 to the most recent dividends), dividends across these top 10 companies have increased by 15%. The RBA calculator measures inflation over the same time as 9%. Even over a time that is as difficult as any in Australia’s sharemarket history, dividends have increased at a rate slightly better than inflation. It is interesting to think about the long-term. Credit Suisse and the London Business School publish a ‘Global Investment Yearbook’, and they found that the long-term growth in dividends in Australia (1900 to 2010) was 1.1% a year higher than inflation.

Company earnings, earnings growth, dividend policy and dividend growth are all risky. However, the long-run evidence, as well as more recent evidence that focusses on the period around the global financial crisis, suggests that dividends do a reasonable job of increasing at a rate similar to the rate of inflation. This is an important characteristic, as we consider increasing periods of retirement, where we will look to put together investment that will, among other things, put us in a position to counter the potential loss of value of our investments at the hands of inflation.

Every day we are confronted by the reality of movements in the value of shares, but it is important not to overlook the value of dividends that they provide to owners over time.