Dividends important for superior long-term investment results

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The need to generate income in an uncertain investment landscape with rock bottom interest rates in some of the largest capital markets has lured investors into riskier parts of the bond market or to the safer, and more traditional, money market route which delivers negative real returns. An attractive alternative for generating income is to invest in superior quality high dividend-paying companies that possess the characteristics required to weather uncertain economic times.

Amongst other attractive features, shares which offer a dividend reduce the need to chase speculative capital returns: the dividend payment acts as a shield against periods of high volatility. To this end, the global dividend strategy series published by Credit Suisse highlights the power of this investment approach. The research shows that across twelve countries for the period 1990 to 2008, shares with high dividend yields generally outperformed shares with low yields.

When the researchers drilled down to individual markets, a time series analysis of the S&P 500 index revealed that the dividend contribution to total return increased from 42% in the mid-1990s to 62% in the mid-2000s. This implies that the dividend yield contribution to total investment return has grown in relevance and should not be underestimated and, if anything, should form a central part of investment decisions.

Yield traps

However, investors need to be wary of yield traps when seeking out high dividend paying stock. These traps arise when dividend yields appear high and attractive but, in fact, are not sustainable. This occurs when the share price declines substantially relative to a past dividend or when a company with deteriorating earnings attempts to preserve its dividend. Thus, it is critical that investors examine a company's dividend sustainability and growth over time.

To sustain and grow dividend payments a company needs to reinvest a portion of its earnings and so cannot pay out all of its earnings, growth prospects need to be reasonable, earnings have to be underpinned by cash flow - you cannot eat accounting earnings - and the balance sheet of the business must be unstrained by excessive leverage.

Whilst there are instances of companies that can pay out high levels of earnings and sustain their business prospects, such as a niched business in a mature industry, it is generally the case that a company which pays out an extraordinary proportion of earnings is signalling an absence or shortage of reinvestment opportunities to enhance shareholder value. Such companies may struggle to grow or sustain earnings resulting in compromised growth and stunted dividend payments.

Cash flow

Arguably, one of the most important metrics to pay attention to when seeking out dividend champions is free cash flow and the stability of cash flow relative to earnings. This number gives a sound reflection of the amount of cash that is available after a company has covered all its expenses (including debt obligations and capital expenditures). A free cash flow number that is highly volatile from year to year, making the dividend amount and payment uncertain, introduces an element of risk for the dividend seeker. The higher the free cash flow a company is able to generate relative to earnings, and the lower the volatility of this ratio, the more attractive it becomes from a dividend yield perspective.

Conversely, if a company has negative cash flow (which may be the case for many start-ups) it indicates that it is unable to generate sufficient cash to support the business or that a company is investing heavily to grow their business. Negative free cash flow is not necessarily bad in itself if the result is a company that makes large investments that earn a higher return for the investor in time. But these businesses are unlikely to become dividend payers in the near future, making them relevant for shareholders who don't require regular income payments and who are prepared to stick with the company for the long run.

Debt position

Another essential consideration is a company's debt position and its ability to service that debt. A highly leveraged company has to pay a larger chunk of earnings to debt holders, leaving a relatively smaller piece of the pie for equity holders. From this vantage point, companies which use lower debt and which can comfortably service their debt are more attractive than those with high debt who experience difficulty in meeting their obligations.

Investing in a well-chosen, diversified selection of dividend paying shares is an asset to any portfolio and this is especially valid in today's yield-starved environment. Studies conducted over various time frames and markets have found that dividends are an important contributor to superior long-term investment results. High quality dividend-paying stocks that trade at a discount to their intrinsic value have the potential to preserve and grow capital over time whilst reducing overall portfolio volatility, three characteristics that are essential for the income seeking investor.