Is growth really the only game in town or is income investing about to have a renaissance? Income specialist fund manager Emma Mogford gives two reasons why history may be about to repeat itself.
The performance of dividends reinvested in the average decade
Dividend contribution to total return, S&P 500 Index
Source: Bloomberg, S&P 500 Index. Data as at 31.03.2023. Past performance is not a reliable indicator of future returns.
I am a big fan of studying the history of financial markets. We can learn so much from the success and failures of the past. Recently I came across data showing the long run importance of dividends to equity investors. The chart above shows that over 60% of total return has come from dividends reinvested in the average decade.
I think investors frequently underappreciate the benefits of dividends. Take National Grid as an example. A boring UK utility. However, if you had held shares in the last decade, you would have doubled your money (it generated a 99.9% total return from August 2014 to August 2024)! But only 10% of that return has come from an increase in the price of the shares, and a whopping 90% from the dividends reinvested.
Of course, the recent experience of the 2010s and 2020s has been very different. Around 20% of returns have come from dividends reinvested, which has led investors to place less emphasis on them. In behavioural finance this is known as the ‘recency’ bias, as humans tend to place greater importance on recent events.
Instead of focusing on dividends, investors instead have shifted to looking for capital gains. So, the big question now is: ‘Have markets fundamentally changed and growth is now the only game in town or is history about to repeat itself and dividends will once again be big drivers of total return?’. I am inclined to believe history will repeat itself for two key reasons.
Firstly, the potential for capital returns is closely related to the starting valuation. The price of global markets relative to the underlying earnings, or the P/E ratio, is currently elevated relative to long run history. And if you start with expensive stocks its harder to see the price rise.
Secondly, the economic environment of ultra-low interest rates and quantitative easing appears to have come to an end. This was an environment that was very good for growth stocks and drove some fantastic returns for equity investors. However, the future would currently appear to have a bit more inflation and higher interest rates (as was considered normal before the global financial crisis in 2008) and in my view that is good for dividend paying companies.
I believe income investing will have a renaissance in the coming years. Indeed, we have already started to see income as a style outperform with the IA UK equity income sector significantly ahead of the IA UK All Companies sector over the last three years. Of course, the other benefit of investing for dividends is that your investments can pay you an income without having to sell any units. That can be very useful if you want a retirement income or to pay school fees, but don’t want to run the risk of having to sell some of your investments in a market downturn.