The Hunt For Yield

It seems like everywhere you go these days people are talking about the “yield”. The rationale goes something like this: global central banks have sought to drive investors into higher yielding assets by buying up long term government debt (and thereby depressing its yield), consequently investors have sought higher yield wherever it can be found, and some of that cash has flowed into higher dividend paying shares. The argument sounds logical and arguably even has some empirical merit, but its weakness is that it implies that investing in higher yielding equities is a cyclical phenomenon that only offers attractions in the current exceptional circumstances. In fact investing in higher dividend yielding stocks has proved over very long periods to be remarkably rewarding.

If we look at the long run history of stock market returns it is clear that dividends have been an enormously important component of returns.

Let’s start with the New Zealand experience.  If we compare total cumulative return, including reinvested dividends, of the NZ market over the last 15 years with the return produced by movements in share prices alone, it is clear that dividends have provided the bulk of the return. Over that period the S&P NZX50 excluding dividends has returned a compound annual growth rate of 3.14%. The S&P NZX50 Gross (i.e. including reinvested dividends) has returned 8.97% p.a.  That annual difference, which is purely driven by reinvesting dividends, means that for $100,000 invested on 31 March 2001, capital growth on its own would have seen the initial investment grow to $158,930, a 59% return. But counting re-invested dividends, the same amount would have grown to $362,547, a return of 263%.

If we look at a very long time series of returns for the US market, we see a very similar result. The most comprehensive work on long term investment returns has been done by three London Business School Finance academics; Elroy Dimson, Paul Marsh and Mike Staunton. Their work in the US shows that in the period from 1900 to 2012, the real return on equities was 6.3% per annum including reinvested dividends, but only 2% from capital appreciation alone. Again taking $100,000, the capital return accumulated over the 112 year period would be $818,796, a return of 819%, but the return including reinvested dividends would be $93,696,987, a return of 93,597%! (Note that if we update these numbers until the end of 2015 the gap closes only very narrowly: respective compound annual growth rates for capital only and capital plus reinvested dividends become 2.27% and 6.57%).

Now it is important to note that investing for capital gain and investing for dividend yield are not mutually exclusive endeavours. A broad portfolio investment across the Australian and New Zealand share markets will normally include many stocks that pay dividends, even if the focus of the investment is growth focused. This is simply a reflection of the fact most stocks pay dividends but it is also worth noting that our local markets are very high yielding compared to most other markets around the world. Currently, according to Factset consensus data, the 12 month forward forecast gross dividend yield on the S&P NZX50 is 5.9% and on the S&P ASX200 is 6.5%. Over long periods the major driver of returns has been dividends and we should be loathe to underestimate their contribution when putting together portfolios.

Moreover, there is a lot of other evidence from around the world that investing in the higher yielding parts of the market has generated superior returns to investing in lower yielding (and perhaps theoretically higher “growth”) stocks. One example, again from the American experience over a long period, used a method of dividing the US market at the beginning of each calendar year into 4 buckets:  the highest and lowest 30% of yielders, the middle 40% of those with yields, and the fourth bucket is those that have no dividend.  The data was compiled by Kenneth French and it covers the period from 1927 to 2010. Over the course of the measured returns the zero yielders returned 8.4% p.a., the low yield bucket returned 9.1%, the middle yielders 10.3% and the high yielders 11.2% p.a. The compounding effect resulted in a cumulative return to the highest yielders nearly 8 times as large as the lowest yielders, and 87% higher than the middle yielders.

Perhaps one of the reasons that high yield strategies have worked well is that, at the most basic level, yield is investment jam today. In a world where our ability to predict the future is significantly more limited than we would like to believe, there is a real attraction to receiving a high yield in the near future. The world is very unpredictable, competition is very real, and sustained earnings growth is hard to achieve. Market analysts are perennially optimistic about the ability of individual companies to grow their earnings at rapid rates but the long term evidence is persuasive – growth on average over long periods is modest.

An argument sometimes made against following a high yield investment style is that it limits growth. Companies that have good growth opportunities, the theory goes, should not be forced by shareholders to pay out earnings to shareholders when it would be better used to develop the business. This is 100% correct. Where companies can generate good returns on investment they absolutely should reinvest in their business. However, the reality is that many companies are unable to find attractive reinvestment opportunities. Too often management make poor decisions and engage in empire building. One of the attractions of high payout ratios (which usually goes hand in hand with high dividends) is the discipline they impose. Management who know they are dependent upon a constituency of dividend valuing shareholders are unlikely to make foolish acquisitions or approve questionable capital expenditure in the quest for often illusory growth.

In the investment landscape we have today, where the traditional sources of income are no longer offering very attractive returns, many income investors are looking to high yielding equities as an alternative. Depending on individual circumstances that may or may not be an appropriate strategy. What is clear though is that as a way of investing in shares over time, a focus on high dividend yield has many attractions. And it’s been that way for a very long time.

Nick Dravitzki - Portfolio Manager

March 2016 Interest Piece