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Your Money > Investing Comment Articles > Returns too slender...
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By Richard J Hunter, Head of UK Equities, Hargreaves Lansdown
Investing in its most basic form has one of three aims - capital growth, income growth, or a mixture of both. Often overlooked as a subject in its own right is the income element of this mix and, in particular, the power of compounding dividend returns. By screening the top companies for a dividend return in excess of the FTSE100 average of just over 3% at the time of writing, the top 5 companies are (listed along with their yield) - BT Group (4.3%), Vodafone (4.5%), Alliance & Leicester (4.6%), United Utilities (6.1%) and Lloyds TSB (6.1%). (as at 07.11.06) There is, of course, no guarantee that companies who have paid a high level of dividends in the past will (or can) continue to do so in the future. So the yield should not be considered alone, since a sudden change in circumstances could, for example, reduce revenues and subsequently require a cut in the dividend. Consequently, the other crucial factor which needs to be considered is called the dividend cover, which is the number derived from dividing the earnings per share by the dividend per share - that is, how easily a company can pay a dividend out of its profits. Again, as a general rule of thumb, investors are comfortable with anything over 1.5 dividend cover, although interestingly two of the five stocks mentioned above fall foul of this benchmark. Indeed, the market has voiced concerns that over the longer term, the level of Lloyds TSB's dividend may not prove sustainable. Indeed, what some investors currently see as a lack of growth potential could be delivered by an acquisition, funded by a cut in the dividend. No such worries have as yet been voiced over the cash generative United Utilities - which has traditionally paid a higher dividend due to its strong and predictable cashflow.
In addition, in a flat or even bear market, yields can make the difference between making a positive return - consider a company paying a 7% dividend, whose share price falls 5% - a total return of 2%. If that company had been paying a dividend of 3% (approximately the FTSE100 average) the total return would have been -2%. It is also fair to say that the market looks very dimly on dividend reductions - so large, well-known companies may well think twice, due to any potentially adverse publicity, before cutting the dividend - this is not a guarantee, of course, but it is a guideline. It would be remiss when discussing dividends not to remind investors about the very powerful tool of compounding, that is, the reinvestment of the dividend into the stock. By looking at studies of equity returns over the years, it quickly becomes apparent just how important it is to consider the dividend and not just the capital element. In particular, the reinvestment of dividends can have dramatic results. For example, £1000 invested in equities at the end of 1899 would, by the end of 2005, have given a return in real terms of £1970. With income reinvested, however, this figure would have been £224 260, over a hundred times greater. (source: Barclays Capital Equity-Gilt Study 2005). As capital appreciation tends to take centre stage during bull markets, so income appreciation grinds away slowly in the background - as part of an overall balanced strategy, however, there is certainly room for both. Richard J Hunter Head of UK Equities Hargreaves Lansdown Stockbrokers |
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