When it comes to matters of investment, it’s often easy to overlook the impact of dividend income on total returns. Brian Tora reflects of the perils of inflation and how an equity income approach can help to offset its worst effects
How often do you think about the purpose behind investing capital for your clients? I suggest that in many cases it is to generate an income that will provide some protection against inflation. While the rise in the cost of living in the UK has been subdued for some time now, rampant inflation has undermined living standards within my memory. In the mid-1970s the inflation rate soared above 20% – not quite Venezuelan or Weimar Republic levels, but sufficient to create real hardship for many.
After the stock market crashed in the autumn of 1987, a leading fund management house ran an interesting advertisement. M&G had launched the Dividend Fund a quarter of a century earlier. With investors shell shocked by the rapidity of the decline all around the world, M&G sought to put the dramatic fall in capital values into a longer term context. The firm pointed out that £1000 invested at the launch of this UK Equity Income fund would have generated more than £1500 of gross income the previous year. The message was clear. Forget the fluctuations in capital value. Concentrate on the income generated.
The case for equity income
This simple statistic underscored what many in the investment industry believed to be true. This was that Equity Income – more precisely, UK Equity Income in this particular case – was a safe sector to back for the long term. Many star fund managers cut their teeth running these funds. Some of the highest regarded managers still run money in this sector. Indeed, total return statistics suggest that Equity Income funds continue to perform well against the very wide variety of sectors that are now available.
Not a one way bet
Of course, there have been blips in the delivery of yield that many of these funds have achieved. In the wake of the financial crisis of 2007/08 major banks cut or even suspended dividend payments in order to rebuild their balance sheet. As bank shares had been a stalwart of these funds, the effect was dramatic as capital values collapsed at the same time. Unfortunately for many managers, BP also ran into trouble at around this time and was forced to cut its dividend. Income streams were decimated as a consequence.
The yield gap
It is worth reflecting also on the relationship between equities and government securities (gilts). In the immediate post war period, equities tended to yield more than gilts to reflect the higher degree of risk they represented. During the 1950s and 1960s there was a major shift by pension funds away from fixed interest securities into ordinary shares on the basis that well managed companies were capable of raising their dividends to shareholders on a regular basis, thus providing protection against future inflation.
Equities once more yield more than gilts but still retain the ability to deliver a rising income over the longer term.
Yields on equities fell below those on gilts during this period. The yield gap, as it was known, became a reverse yield gap. And so it remained until the financial crisis of 2007/08 when a combination of low interest rates, subdued inflation and volatile equity markets drove yields on gilts down and re-established the yield gap. Equities once more yield more than gilts but still retain the ability to deliver a rising income over the longer term.
While this may appear primarily to relate to the UK Equity Income sector, the greater availability of high yielding shares around the world means that there is now much more choice for investors. Even Japanese companies have become capable of delivering reasonable dividend returns, while many emerging markets also offer equity income options. It can be argued that the rationale behind the equity income sector is merely value investing, of the type promoted by Benjamin Graham and Warren Buffett. Certainly, companies that pay the investor to remain loyal shareholders by increasing dividends on a regular basis have a considerable attraction.
The collective approach
There are a number of investment trusts that have been able to demonstrate a significant record of increasing the pay out to shareholders over a prolonged period. The City of London Investment Trust, managed by Job Curtis and resting within the Janus Henderson management group, is one example of such a trust. It can point to more than half a century of increasing dividends and the shares, which admittedly stand at a modest premium over asset value, yield more than 4.5%, comfortably above the yield on government stocks.
The threat of inflation
While rising dividends are not quite the given they once were, the fact remains that inflation, even modest inflation, remains a threat to living standards for those on a fixed income.
Equity Income might have looked to be a sector lacking excitement at times and delivering little in the way of Alpha, but for many it appears a prudent investment choice.
True, there are now inflation-linked bonds which offer a degree of protection, but longer term studies suggest a rising income stream from equities is likely to provide the best results, provided that capital value fluctuations in the shorter term can be tolerated. Equity Income might have looked to be a sector lacking excitement at times and delivering little in the way of Alpha, but for many it appears a prudent investment choice.
Brian Tora is a consultant to investment managers, JM Finn.