Dividend power

By Scott Francis August 12, 2011

PORTFOLIO POINT: Higher yields on sold-down stocks could help investors protect themselves against short-term capital losses.

Credit Suisse and the London School of Business recently published the Global Investment Yearbook for 2011 and delivered investors with a tremendous source of long term investment returns.

The 56-page document (click here) contains a comprehensive collection of data across equity, bond and cash markets from around the globe, including Australia, and serves as a very useful tool at a time when great volatility has inspired many to revisit their investment strategy.

This year’s edition has a particular focus on investment yields, which is especially timely when many investors may be considering the higher yields now available on sold-down stocks like Telstra (TLS) as a way to protect themselves against the prospect of short-term capital losses.

Show me the money

Of course the most pressing question is how the Australian sharemarket compares to other sharemarkets around the globe. As we’ve come to expect, the answer is, ‘Quite well, thank you very much’.

The Credit Suisse-LSB report says Australia has had the best-performing equity market since 1900 with an average annual return of 11.6% to 2010, after taking into account both capital growth and dividends.

It also mentions that the conservative US think-tank The Heritage Foundation views Australia as having among the highest economic freedoms in the world, beaten only by a few city states. Are the two linked? I couldn’t say.

But what I do know is that the headline returns of 11.6% a year would imply that your investment would double every six and half years. So are shares the perfect investment? Not quite. The 11.6% annual return came with quite a lot of volatility.

The standard deviation of returns was 18.2% a year. The standard deviation measures the spread of returns, and in rough terms at 18.2% a year it means that in any given year two thirds of the returns would be between –7% and 30%, with the remaining third above 30% or below –7%.

There should be a warning when talking about the standard deviation of returns – there is a thought that there is a “long tail” of returns – that is, years with particularly bad returns happen more often than they should, a view that is reinforced by the events of the past few years.

That said, annual average returns of 11.6% a year from Australian shares fit with most calculations of long-run expected returns from share-based investments. So a reasonable question to ask at this point is, are these the likely returns that we will get in the future?

I think there are two very good reasons to have more modest expectations of future returns. The first is that between 1900 and the end of 2010 the “real” return (after inflation) was actually 7.4% a year. This is important because it measures the actual spending power of your returns by factoring in the ever-increasing price of goods and services.

It is also important to note that the Australian sharemarket is considered by the report to be the best-performer over this period, which means that the law of averages suggests we should be cautious about projecting these historical returns going forward.

The report also looks at the return from bonds (click here) and bills (click here). Over the 111-year period the average annual returns and volatility were as follows:

How they performed: 1900 to 2010

It is worth noting that these returns do not include the impact of tax. The current franking credit tax regime in Australia, along with the discount for long-term capital gains, means shares are likely to suffer less at the hands of the tax office. Indeed, for an investor or superannuation funds on 0% or 15% tax rates, after-tax returns for Australian shares are likely to increase because of the impact of franking credits.

Regular payments are better

It is now nearly four years since the market peaked in late 2007. Since then price volatility has tended to be first and foremost in the minds of shareholders while the issue of dividends, which provide up to half of the returns from equity investments, is often overlooked. This year’s Global Investment Yearbook took a particular interest in the issue of dividends and makes several important observations we should all consider.

The first is that the average annual growth in dividends across the world between 1900 and 2010 has been 0.8% higher than inflation. This is a particularly attractive aspect of dividends: they provide the investor exposure to an income stream that generally keeps pace with inflation.

In Australia the growth in dividends has been slightly higher: 1.1% a year greater than inflation. Conversely, dividend growth in a number of countries (including Japan and Germany) has not kept up with inflation over this period.

The yearbook also points to the higher returns achieved by investors from investing in higher-yield shares, which it refers to as the “yield effect”. The report supports this observation with data from two studies, in the UK and the US.

The UK study looked at data from 1900 to 2010 and found that “low yielding” companies provided an average annual return of 8% a year, whereas for higher-yielding shares it was 10.9%. The US study looked at returns between 1927 and 2010, and found that low-yield stocks had an average annual return of 9.1%, compared to higher yielding stocks at 11.2%.

From 1975 to 2010 the “yield effect” in Australia is reported as 5% a year. This means that the highest 30% of companies by yield have outperformed the lowest 30% by 5% a year. Over the past 10 years the yield effect has shrunk considerably, to 1.5% a year.

Given the franking credit tax system in Australia, this additional return is unlikely to come at any significant tax cost, however it is rarely as simple as just buying high-yielding stocks and enjoying a free lunch.

Higher-yielding shares are often seen as “value companies”, companies that offer higher levels of earnings and dividends for their price. This may be because they are riskier and have fallen in price. Consider the banks during the GFC, for example. They had relatively strong dividends and earnings compared to their prices but they were cheap because they were most exposed to the stresses on the global finance system.

There is no doubt that the volatility of the past three years makes being an investor a challenging exercise. However, keeping an eye on the dividend income produced from a sharemarket investment, understanding the potential for dividend growth and being aware of the long-term benefits and risks of investing in asset classes allows for well informed decisions.

The 2011 Global Investment Yearbook (click here) is a useful tool as investors compile or revise their investment strategies.