Dividends: the Ninth Wonder of the World?

By Paulo Senatore and Franco Barnard, Ashburton Investments

One hundred rand invested in 1995 would be worth R1 400 today, if dividends were reinvested. Where dividends were drawn and not reinvested, the same R100 would be worth only R855.

dividendsAlbert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

While dividends may not quite be the ninth wonder of the world, dividend returns within equity investments are often under-rated. Dividends have a significant impact on investment returns and should therefore play an important role when making investment decisions.

In general, companies list on a stock exchange in order to raise capital. This capital is used by companies so that they can expand and grow their businesses. Investors purchase shares in companies primarily for inflation-beating returns over time. In selecting a specific company, consideration is given, amongst other factors, to the quality of management, industry exposure, geographical spread and the business model. In the final analysis, superior returns are achieved by choosing to invest in companies with superior profits and the ability to grow these profits over time.  These profits are usually either distributed to shareholders via a dividend, share purchases, or retained by the company to grow the business. In most cases, a portion of the earnings are paid out as dividends whilst retaining the balance for growth. The ratio of dividend payments to retained earnings depends on the business cycle and the maturity of the company.

When a company is newly listed and in its growth phase, or in a cyclical industry, the dividend pay-out ratio is usually low. Good examples are Aspen, Discovery and Naspers which are companies that retain most of their profits to invest in growth opportunities. In contrast, certain companies have high dividend pay-out ratios either because growth opportunities are limited or the company is in a mature phase. Companies that come to mind here are Vodacom (in 2013 they paid out 90% of profits in dividends) and Coronation (in 2013 the paid out 100% of profits in dividends).

The true benefit for investors really lies in reinvesting dividends received back into the companies that paid the dividends. This creates an “Einstein-like” compounding effect. The chart below illustrates the positive effect of reinvesting dividends in the FTSE\JSE All Share Index. One hundred rand invested in 1995 would be worth R1 400 today, if dividends were reinvested. Where dividends were drawn and not reinvested, the same R100 would only be worth R855.

Graph-1

A company’s dividend policy and dividend history is an important consideration when making investment decisions. To illustrate this concept the share price movement and dividend distribution of Standard Bank over the last 20 years is discussed:

Graph-2

The first observation is that there is a strong correlation between the share price (red line) and the dividend per share (blue line). When profits grow, dividends increase which underpins the share price.

The Standard Bank share price at the beginning of 1993 was R7.70 and the company paid a dividend of 19c per share. Standard Bank increased their dividend every year between 1993 and 2008 when the United States sub-prime financial crises impacted the world. What is remarkable is that even during the financial crises which prompted a selloff in global equity markets, Standard Bank managed to maintain the dividend pay-out. If R10 000 was invested in Standard Bank in 1993 one could have purchased 1 300 shares. The value of that investment, 20 years later, would be worth R156 000. That’s a 1 456% increase in the share price alone. What’s more, the value of your dividend in 1993 would have been R247 (1 300 x R0.19) but by the end of 2012 the dividend would have risen to R5 915 (1 300 x R4.55), an increase of 2 300%.

While dividends remain an important income source for many investors as they usually increase as profits increase, the after-tax returns provide further attractiveness. Until recently, dividends were tax free. However, since April 2012, tax legislation changed and investors are required to pay a 15% dividends withholding tax (certain entities are exempt).  Nevertheless, even after dividends withholding tax, the dividend yields for some shares remain very attractive with respect to cash yields. For example, the after-tax dividend yield for Vodacom is currently just below 6%, whereas one-year cash yields are 5.57% (pre-tax).

In summary, dividend distributions increase as companies expand and profits grow. These dividends, when reinvested, can generate significant compounded returns over the long term. Are dividends the ninth wonder of the world? No they aren’t, but it is clear from the examples presented that dividends are a significant contributor to investment returns and should not be ignored when making investment decisions.

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