Dividends are ingrained in our investment culture.
The ability to generate excess cash and return it to shareholders is undoubtedly a sign of financial strength. But strange though it seems, particularly as the manager of an investment income fund, I am becoming increasingly concerned about some companies' pay-out policies. Nice though these quarterly, half-yearly or annual shareholder rewards may be, we need to consider what is being sacrificed or risked in the name of maintaining or increasing them.
There are UK companies with lengthy track records of increasing their dividends - some have done so for 40 years or more. Dividend culture is not just a domestic phenomenon, however. It is well established in Europe, and in Latin America, where companies understand shareholders' demand for recompense. European firms pay dividends just as reliably as their UK counterparts. And while capital gains and share buybacks are preferred in the US (dividends have been taxed at a higher rate), tax reforms are slowly changing investors' attitudes.
Elsewhere, Asian companies have embraced the idea of dividends, in order to attract investment funds. As a result, a dividend culture is gradually becoming established - though it varies across the region. Firms in emerging markets are also increasingly using their earnings to return value to investors.
Dividend-paying companies look attractive, particularly those that increase their pay-outs from year to year. In the current climate of financial repression, few liquid securities offer the potential for inflation-beating income growth. On the other hand, however, history has proven that reinvesting dividend payments over the long term produces far greater returns for investors. With dividends taken as income, £1,000 invested in the FTSE World Index twenty years ago would equate to around £2,973 today; had the dividends been reinvested, the return would be more than 50per cent greater at £4,628.
While the principle of returning cash to shareholders is important, it certainly shouldn't be sacrosanct. The recessionary backdrop across Europe, slowing growth in Asia and emerging markets and the mixed recovery of the UK and US economies is a difficult environment for many companies. On top of this, some sectors are suffering more than most. Oil companies which have a tradition of paying dividends are under pressure, following the sharp drop in the price of Brent crude.
With few opportunities to grow their top line, many firms are cutting selling prices of their goods and services in order to maintain profits, which directly influence their ability to pay dividends. The price wars and 'races to the bottom' that are emerging in certain sectors are deeply troubling. The risk is that, over the long term, businesses could lose their sway and become price takers.
Another concern is that companies may feel compelled to cut back on capital expenditure and research spending in order to maintain dividends; by sacrificing long-term investment budgets, a company risks missing out on long-term growth. In a nutshell, that's why it's so important to analyse a company's balance sheet before investing, and to keep an eye on developments once you've taken a position. An increasing number of companies are paying uncovered dividends, where at least part of the payment comes from reserves. This is fine as a one-off event, but it is not a sustainable strategy. Even if the dividend is covered by profits, the key question is how they were earned.
Fortunately, despite the present global economic environment, there are companies out there that are achieving both top-line and dividend growth. These businesses are not confined to one region or sector but are spread across the globe. They offer - for those willing to do their homework - the opportunity to gain exposure to solid, profitable enterprises.
At heart, I am a big fan of dividends, but not those companies which pursue an 'at all costs' mindset in maintaining their payments to shareholders. The costs of such a strategy far outweigh the benefits.
Bruce Stout is investment manager , Murray International investment trust
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