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The importance of dividends

27 August 2020 Chantal Marx, Head of Research and Nicholas Riemer, Head of Investment Education at FNB Wealth and Investments

When investing on the stock market the change in a company or index share price only tells one half of the story. Many companies pay dividends that form an important part of an equity investor’s return profile.

What is a dividend?

Dividends are a share of company profits paid out to shareholders. The board of directors approves the percentage of profits declared as a dividend, while the remainder of profits are retained within the company for future use – usually to fund growth or maintain the operations of the business.

Dividends are usually paid by more mature, established companies. As these companies are not necessarily looking for aggressive growth, and cash flow patterns tend to be more predictable, profits can be distributed to shareholders in the form of dividends.

Some companies may pay a dividend, but it may not be a major driver of return because the share price is high relative to the expected dividend payments. Therefore, one must consider the dividend yield of a company before buying a share for its dividend. The dividend yield is calculated by dividing the company’s total dividend per share for the year by the price of the share, and this shows the investor the gross dividend return. This ratio can be utilised to analyse the company’s previous dividends declared (trailing dividend yield) or future dividends to come (forward dividend yield). By considering the forward dividend yield when making an investment decision, one can identify companies that are expected to pay decent dividends in the future.

Dividends in a portfolio

JSE All Share Index versus JSE All Share Total Return Index

Source: Bloomberg, FNB Wealth and Investments

Selected indices – proportion of return from dividends

Source: Bloomberg, FNB Wealth and Investments

Investing in dividends

• Invest in companies that you expect will pay dividends going forward: To do this you will need to identify companies and industries that would have had minimal disruption to cash flows during the lockdown period. But even then some may opt not to pay a dividend. South African listed companies usually provide this type of guidance through announcements on the JSE’s Stock Exchange News Service (SENS) and on the investor relations tab on their respective websites.

Smart Beta – ETF providers: Coreshares runs a range of exchange-traded funds that track an index with certain rules that only allows for it to invest in companies that are expected to pay high and growing dividends. The Coreshares DivTrax invests in local shares and the Coreshares Global Dividend Aristocrats tracks international shares with a good dividend payment profile.

Let the professionals do the job for you: There are unit trust funds available both locally and offshore that pick stocks that are expected to pay good dividends going forward. Locally, FNB offers an FNB Dividend Income Portfolio and internationally the FNB Global Equity Income Portfolio invests in stocks offshore that are expected to pay good dividends going forward.

Current market dynamics
The COVID-19 outbreak and subsequent economic fallout has resulted in many companies opting not to pay dividends because their operations have been heavily disrupted or are expected to be disrupted in future. Some companies are opting not to pay dividends simply because the operating environment going forward is so uncertain and they believe it is prudent to rather preserve cash during this time. Others (like the banks) have been directed by regulators not to pay dividends in the near term.

There will, however, still be companies that pay dividends during this time or are planning to resume dividends soon. Identifying them now could be a good way to pick long-term investments that will operate with less disruption during this time. The risk remains that a prolonged economic downturn weighs on the share price or dividend profile going forward – for this reason it is best to try to avoid cyclical companies that may pay a dividend over the next few months but could see cash flows come under pressure very quickly should market dynamics shift.

Another consideration is that – because high dividends tend to be paid by more mature companies – investors may "miss out" on exciting high-growth stocks and the positive market sentiment surrounding these stocks. Fear of missing out has no place in a dividend investing strategy, however, and investors will likely be rewarded for holding these more mature companies when markets come under pressure.

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