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Don’t be deceived by dividends

Lady wearing a head scarf looks over pages on company financials
Image source: Getty Images

When I first got serious about investing 20 years ago, dividends were all the rage.

Newer Fools who cut their teeth in the era of meme stocks and millionaire-minting crypto coins might find that hard to believe.

But remember this was just after the Dotcom bust. Portfolios had been sliced in half by plunging indices.

The formerly highest-flying firms were now lumped into the so-called 90% club – a measure of how far their prices had fallen from the peak.

Many investors professed they were done with growth stocks.

Phooey to ephemeral high prices! They wanted profits, cash flows, and cold, hard dividends paid into their accounts.

At the same time, and not coincidentally, value shares – cheaper companies that often sported generous dividend yields – had been outperforming even as the tech stocks slumped.

Down with dividends

It seemed for a while like dividend investors could have it all.

Strong portfolio growth as well as a tasty income on top? Don’t mind if I do…

Strategies such as the High-Yield Portfolio – where you bought and held a basket of high dividend-paying blue chips – became massively popular among UK Fools.

Such investors were reassured by data that appeared to show how dividends represented the bulk of long-term stock market returns.

Prices might flit about like youthful infatuations – but you could commit to your dividends for life.

Alas, one of the only perpetual truths in investing is that when something is near-universally lauded as a no-brainer, it’s probably time to look for the exit.

Dividend investing’s aura of invincibility had a few years left, but sure enough the wheels came off in the global financial crisis of 2007 to 2009.

In particular – and despite being thousands of miles from the epicentre of the crocodile-infested US sub-prime mortgage swamp – British banks got chewed up.

Former chunky dividend-paying darlings like Northern Rock and HBOS either went under or else were taken over by rivals. The bailed-out banks were then expressly forbidden by regulators from paying dividends for years.

It all caused real distress to the many (often retired) investors who’d made ‘safe’ blue chip banks the bedrock of their high-yield portfolios

Meanwhile by 2010 – though nobody knew it yet – a new bull market in growth stocks had begun.

Value and dividend investing strategies would go on to underperform for more than a decade.

A question of cash

For the UK’s dividend payers, the peak pain came with the pandemic in 2020.

You may remember how the initial plunge in global markets on news of a new deadly virus had largely reversed by the end of the year, with the tech-heavy US market in particular surging.

Tech giants were prospering from us working from home and the world going more digital.

At the same time, a plethora of smaller blue-sky growth stocks did well simply because their profits had not been expected for years anyway.

Rock-bottom interest rates that had been cut to salve the economic slowdown meant little was lost by waiting for profits that were not due until the far-flung future.

However, it was a different story for most of the sort of ‘old economy’ companies that tend to pay good dividends – particular in the UK.

  • Energy companies saw their businesses collapse as countries were put on standstill.

  • Retailers and hospitality firms literally shut up shop.

  • Offices were empty, and rental streams for the REITs that owned them evaporated.

You can’t pay cash out to shareholders via a dividend when there’s no money coming in.

Past the peak

This disruption to daily life was unprecedented outside of wartime. Not surprisingly, it led to a staggering collapse in dividend income in 2020.

Globally, total dividends paid out by listed companies fell by one fifth that year.

But the UK had it far worse. Dominated by old-line dividend-paying stalwarts, dividends paid out by London-listed firms fell by 44% for the year to £61.9bn.

It was the lowest level since 2011. We’d come full circle.

In the wake of the Dotcom crash, focusing on the relatively steady dividend payouts from more traditional companies had seemed more attractive than relying on the wild swings of share prices.

But now, with the novel coronavirus raging all around us, global share prices held up better than those once apparently steadfast dividend payouts.

The UK’s FTSE 100 was a woeful performer in 2020 – falling 11.5% for the year versus a nearly 18% gain for the US S&P 500.

Yet even that loss was a far milder fall than the crash in UK dividends.

Dividends down but not out

The good news is dividends have bounced back as the world has reopened and most companies – not least the energy firms that loom so large in the UK stock market – have recovered.

Shell just announced its highest annual profits for 115 years, for example.

Nonetheless, it will still be years before total dividends finally surpass the £110bn peak of 2019.

Indeed, according to new data from fund administrator Link Group, total payouts are forecast to fall 2.8% to £91.7bn for 2023.

The decline is down to fewer bumper ‘special’ one-off dividends that inflated last year’s tally – particularly from the UK’s mining giants. Thankfully, underlying dividends from UK companies should continue to edge upwards – by a forecast 1.7% this year to £86.2bn in total.

Building in buffers

I believe this two-decade whiz through history demonstrates that dividends can take investors on just the same sort of unsettling ride as gyrating share prices.

True, we’d be unlucky to see another pandemic that puts the global economy on pause.

But something else will come along eventually.

Does this make dividends undesirable – or even dangerous?

Not at all.

For me, they are just another capital allocation decision to be taken by company management. As an investor, I want my managers to decide where best to allocate spare capital – expansion, repaying debt, dividends, or share buybacks – according to the needs of their business, not whether the vogue in the market is for cash today or growth tomorrow.

But what about investors who want dividends to deliver an income – maybe in retirement?

I believe it remains a valid strategy. But it must take into account this reality of uncertain payouts.

At the least, you need to have a year or two of living expenses held in cash and short-duration bonds. That way you should be able to ride out any future dividend droughts like 2020.

Alternatively, you can outsource the smoothing of income payouts to fund managers. I’d favour UK equity income trusts with long track records. (And I’d still have a cash buffer…)

Just don’t kid yourself that you’re getting a free lunch by investing in dividend payers. Sometimes income will outperform, at others capital growth will shine. Personally, I’ll stay agnostic about dividends. It’s harder to be disappointed that way!

The post Don’t be deceived by dividends appeared first on The Motley Fool UK.

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The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Motley Fool UK 2023