How to use dividends to your advantage

The pandemic caused dividends to become outdated

James Mackreides says it's wonderful to see them again.

"If a true investor ignores the stock market and focuses on dividend returns, he will perform better. "Benjamin Graham."

One of the main drivers of equity market returns has always been dividend income, particularly during volatile or bear market times. According to data gathered by Bloomberg and Guinness Global Investors, income accounted for almost all of the index's returns during the 1970s and 2000s, both times when the SandP 500 experienced significant market volatility. The index grew by 76.9 percent in the 1970s, with price appreciation accounting for 17.2 points and dividend income for 59.7. The index dropped by 24.1 percent in the 2000s, but dividends increased by 15 points, resulting in a -9.1 percent return overall.

The importance of dividends increases with the duration of investment. According to Guinness Globals data dating back to 1940, dividend income contributed only 27% of total return over rolling one-year periods, but that percentage increased to 57% over rolling 20-year periods. Additionally, they show that £100 invested at the end of 1940 with dividends reinvested would have been worth roughly £525,000 at the end of 2019, as opposed to £30,000 with dividends paid out. Ninety-four percent of the index's total return during this time came from dividends and dividend reinvestments.

In the UK, the same pattern has been noted. The average annual return produced by the FTSE 100 between January 1, 2000, and December 31, 2019, was a mere 0.4%. However, Schroders' calculations show that the index has actually returned 122 percent over the same period (or 4 percent annually) if dividends are taken into account.

Challenges facing dividend stocks during the pandemic.

However, the numbers only cover 2019 for a reason. This relationship has disintegrated since the pandemic. According to S&P Global's most recent data, since 1926, dividends have contributed roughly 31% of the S&P 500's total return, while capital appreciation has contributed 69%. The performance over the previous five years is largely to blame.

Dividend stocks, as defined by the S&P 500 Dividend Aristocrats index, have generated a total return of only 9% annually since the end of 2021. This is in contrast to the 15.6% annual return for the S&P 500 index as a whole. According to Hartford Funds, this decade's dividend contribution to the S&P 500's overall return has been the lowest on record at just 12%.

Equity returns have been "driven by a positive re-rating of equities, particularly in the US and particularly in technology stocks," according to Ian Lance, co-manager of the Redwheel and Temple Bar Investment Trust. The pandemic years also had a disproportionately negative impact on dividend stocks. According to Janus Henderson, £220 billion in dividends were either stopped or reduced in 2020.

Over 80% of US dividend exchange-traded funds (ETFs) underperformed the S&P 500 during the 2020 equity drawdown period, and half of them did not recover as robustly as the index in the ensuing recovery, according to research by Goldman Sachs.

Additionally, according to Alan Ray, an investment trust research analyst at Kepler Partners, dividend stocks "tend not to perform well when interest rates rise". "Investors who were drawn to dividend-paying companies with conservative management when interest rates were near zero can now purchase risk-free UK gilts with yields of 4 percent or 5 percent, or even just keep cash in a savings account," says Ray.

When the dividend yield is reliable.

History demonstrates that dividend stocks can be a safe haven during times of volatility and uncertainty, despite the challenges they have faced over the past five years. Additionally, compared to their growth counterparts, many income stocks are currently trading at comparatively low valuations, indicating that there is a greater margin of safety with these stocks in the event of a market downturn.

Although there isn't a formal definition of what constitutes a good income stock, most studies on the subject concur that yield and qualityor rather, the absence of itare correlated. Although a dividend stock with a high yield may appear appealing as an income play, the yield is typically a reflection of traders' uncertainty about the payout's sustainability.

According to Murray International Trust co-manager Martin Connaghan, "a high dividend yield is most likely unsustainable and hence false, so there is no point in being drawn in by that yield." If dividends are later reduced, stocks that appear to have very high yields could become vicious value traps. A "

In fact, research indicates that investors should focus on companies that offer yields between two and four percent rather than pursuing high yields. Quality shouldn't be determined solely by yield. Analyzing cash flow quality is the most effective way to assess a dividend payout's sustainability and quality. In the business world, money is king. A good indicator of management's capital allocation strategy is cash flow.

"For stocks with higher yields, it is important to understand the sustainability of that dividend, how much the dividend is covered by earnings and free cash flow, or ongoing capital generation in the case of a bank, and also to think about whether there is anything on the horizon that could change the cash-flow dynamics, such as an increased need for investment," says Imran Sattar, portfolio manager of the Edinburgh Investment Trust. A "

Connaghan concurs, stating that "the ability to sustain and grow dividends is essential." Businesses that have high cash conversion ratios, dividend cover, and free cash flow yield ought to be better equipped to accomplish this. A "

Generally speaking, free cash flow is the cash flow produced by operations that does not include capital expenditures or operating costs. According to a conventional capital allocation framework, if a company has extra money to spend, it should first put it back into its operations if it can generate a profitable and long-term return. The business should use the funds to pay off debt if this opportunity isn't available, and if it doesn't have any debt, it should return the funds to investors.

We can see a true, uncondensed picture of how management is using a company's funds through cash flow figures. Investors frequently use earnings before interest, tax, depreciation, and amortization (Ebitda) as a stand-in for cash flow because that is the metric that businesses typically prefer to use. Nevertheless, this disregards necessary business expenses like taxes, debt interest, and capital equipment replacement.

In a similar vein, a straightforward dividend cover computation, which typically divides earnings per share by the dividend per share, also yields an inaccurate result. Particularly for long-term assets, which can be very expensive for capital-intensive businesses, earnings per share do not fully reflect all capital expenditures. Money leaves the company when it pays a dividend. This means that in order to avoid issues later on, the capital must be genuinely surplus to requirements.

Companies that have overpaid during prosperous times and suffered from poor balance sheets and a lack of support from shareholders during difficult times are numerous in history.

The top dividend stocks.

The best dividend stocks come from businesses that manage their balance sheets carefully, balance operational costs, including capital expenditures, and have reasonable dividend policies. Additionally, the harmful idea of a "progressive dividend policy" is avoided. According to progressive policies, the dividend will increase annually. They are intended to give investors security. Actually, they act in the opposite way.

Businesses will always go through cycles, and committing to raising dividends year after year under all circumstances drives management to make poor choices. When such a policy is in place, it is challenging to reduce a dividend, which frequently places businesses in challenging situations where they must pay out more than they can afford.

Small regular payouts combined with annual special dividends determined by profit over the course of the year make up some of the most sensible dividend policies. Because of the increased flexibility, management can announce more distributions as needed without placing undue strain on the balance sheet. Additionally, managers have the option to switch between dividends and share buybacks, with the latter being simpler to activate and deactivate based on the business climate.

Admiral, a major insurance company on the FTSE 100, is a prime example. The auto insurance industry can be unstable and erratic. It alternates between a soft market where prices decline, competition increases, and insurers must bear significant losses, and a hard market where insurance prices are rising and profits are abundant. Admiral cannot afford to commit to an unsustainable dividend policy because managing a business through this cycle necessitates financial flexibility and a solid balance sheet. Rather, it pledges to pay out a regular dividend of 65% of its post-tax profits each year, augmented by special payouts.

For instance, Admiral declared a regular dividend of 85.9p per share and a special dividend of 29.1p per share for the first half of the year, totaling 115p, or 88 percent of post-tax profit. The group received a sizable interim distribution. The company's annual dividend payout reached just under 280p per share in 2021, a bumper year after the pandemic that forced a shift in driving habits and a significant decrease in accidents. However, as drivers resumed driving and began colliding with one another in the ensuing years, the company lowered its distribution to reflect declining profits. It only distributed 103p in interim and final dividends for the fiscal year 2023.

The CME Group is an additional example. It offers a consistent quarterly dividend, which translates into an annual yield of roughly 2%. This is complemented by a unique distribution at year's end that is determined by the year's trading performance. For instance, the company distributed four regular dividends of £1.15 per share and one £5.25 special dividend at the end of the previous year.

In the mining industry, the dangers of a regular dividend policy were made abundantly evident in 2016. Mining behemoths like BHP, Rio Tinto, Glencore, and Anglo American found themselves in a challenging position that year as commodity prices plummeted and China's once-phenomenal growth began to falter. In addition to committing to large, consistent, progressive dividends based on prior profitability, these businesses also made significant borrowing and spending commitments to finance expansion.

Revenue and commodity prices fell, so something had to give. BHP abandoned its progressive dividend policy and slashed its interim dividend by 75%, the first reduction since 1988. Rio also cut its dividend in half, and Glencore was compelled to undergo a convoluted restructuring that included both a dividend reduction and a £2.5 billion cash call.

In a different instance, BT had to reduce its dividend in 2020 after management realized that in order to stay competitive, the company needed to increase its fiber build-out expenditures. This was a major setback for income investors, since BT was frequently hailed as one of the best income plays in the UK market before the cut.

Where can one find dividend income?

Both the overall quality of the company and sensible capital allocation are good indicators of dividend quality. There are numerous ways to define quality. In his 1996 letter to Berkshire Hathaway shareholders, Warren Buffett put it quite succinctly: "Your objective as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten, and twenty years from now." A "

In other words, a quality business is one that has a long growth trajectory and a significant competitive advantage. Higher-than-average profit margins are another common result of a strong competitive advantage, giving the business plenty of money to invest in expansion, marketing, and debt repayment as well as to give back to shareholders.

The top income stocks are "predictable, resilient, high-quality businesses" that you can "say something sensible about on a five-, seven-, and ten-year view," according to James Harries, co-manager of STS Global Income & Growth Trust. This frequently entails sticking with the businesses that he characterizes as "steady as she goes" because they frequently "grow slower, but grow more persistently".

Nike is a recent addition to the portfolio and a fantastic illustration of the approach. Despite the company's current difficulties, Harries says, "I'm pretty confident that we are buying a really high-quality asset at a very attractive valuation." "It's the highest quality global sports brand." Nike has billions of dollars in net cash on the balance sheet, a gross profit margin of over 40%, and is one of the most valuable and well-known consumer brands in the world. With £591 million in dividends in the first half of 2026 and £18 billion in share buybacks since June 2022, it is also rewarding shareholders.

Additionally, the utilities industry can be a good place to look for work. According to Jacqueline Broers, co-portfolio manager at Utilico Emerging Markets, "a utility company typically operates in a regulated sector that is supported by a long-term concession contract, which will stipulate the return that can be generated over the life of the concession." Cash flows may therefore be more "predictable" and "resilient" than those in other industries. "This results in a longer-term dividend payout that is more sustainable. A "

Broers uses the example of IndiGrid Infrastructure Trust, which owns 41 power projects spread across 20 Indian states and two union territories. These projects include 17 operational transmission projects, three greenfield transmission projects, 19 solar generation projects, and battery energy storage (BESS) projects. The company's transmission assets have an average remaining contract life of just under 26 years, and its dividend yield of roughly 10% is supported by contracted revenues.

The high cost of replacing their assets is another benefit utilities typically enjoy. The majority of the high-voltage transmission network in the UK, which consists of thousands of miles of cables and transmission stations, is owned by the UK-based National Grid. In addition to the enormous expense, it would be nearly impossible to construct these assets from the ground up today. This provides a strong competitive advantage for the business.

Companies that can have this advantage are not limited to utilities. Connaghan cites companies like Grupo ASUR, an airport operator with 16 properties in Central and Latin America that is listed in Mexico. "Cancun airport is its key asset, and over the last 35 years, the company has seen its passenger numbers increase by a compound annual growth rate of 6 percent," he says. "This company's early-year financial strength was so strong that they announced two 15-peso special dividends in April in addition to a regular dividend of 50 pesos. As a result, the dividend yield on the stock was 14%. The "

The fund manager also cites companies like Enbridge, a Canadian pipeline company that uses its network across North America to transport and store oil and natural gas. For thirty years in a row, the company's dividend has increased. "As 98% of its Ebitda comes from assets backed by either regulated returns or take-or-pay agreements, this type of business is far less exposed to the underlying shifts in the commodity prices themselves," he observes.

Trusts for investments that yield dividends.

An investment trust's structure makes income investing possible. In contrast to ETFs and other open-ended investments, they can pay dividends from both capital and income in addition to providing investors with access to a well-diversified portfolio of income stocks. This implies that during times of market volatility, trusts are more likely to be able to maintain their dividends. Additionally, trusts with a global mandate have much greater flexibility in where they can invest, allowing them to select the world's best investments in terms of growth, quality, and income.

The global mandate is shared by STS Global Income & Growth (LSE: STS), Scottish American (LSE: SAIN), JP Morgan Global Growth and Income (LSE: JGGI), and Murray International (LSE: MYI). Within its utility sector, Ecofin Global Utilities and Infrastructure (LSE: EGL) has a global mandate. Others, like Temple Bar (LSE: TMPL) and Law Debenture (LSE: LWDB), focus on the UK but have some holdings abroad.