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6.2. Dividends for Growth

If a company regularly pays a decent dividend, investors don't always expect future capital growth to underpin share price. However, some market participants are much more interested in growth than current income, particularly if their marginal income tax rate exceeds the rate of capital gains tax. They focus on a company's free cash flow (yield plus potential dividend growth) associated with a high payout on undervalued stocks, particularly when profits are expected to rise. If dividends move in sympathy with earnings per share (EPS) they represent the bulk of returns. Potential dividend growth is also a key component of the total return from shares when inflation and interest rates are low because their benefits feed into distributable profits.

Historically, dividends account for the majority of a share's total return. For example, between 1950 and 2000, 80 per cent of investors' gains from global markets were represented by dividend distributions. Investors can also increase their wealth by creating "homemade" dividend growth. For example, if you had invested £100 in the Footsie at the start of 1993, held for a decade spending all the dividends and selling when the market fell to its all time low in March 2003, the investment was only worth £101. If you had reinvested the payouts every year, you would have realized £137.50.

Turning to a sectoral analysis, shares in British American Tobacco (BAT) between 2000 and 2010 rose by a massive 383 percent (equivalent to 17 percent per annum). However, with dividends reinvested, shareholders made an incredible 662 percent, or 22.5 percent a year. Over the same period, the FT-SE All-Share only returned 40 percent with dividends.

So today, if you want to invest for the long-term and reinvest dividends, which sector should you pick? There is no definitive answer. Who would have thought that in 2000 when techno-shares were the best-performing shares of the decade, an industry seriously impaired by smoking litigation would ever revive its fortunes so spectacularly?

Growth investors oblivious to the risks of rejecting a "bird in the hand" strategy outlined in Chapter Three can also be disappointed in the short-term. At a scholarly level, throughout the 1950s and 1960s the American academic Myron J. Gordon (op cit.) explained how a high dividend pay-out ratio supports current share price generally, particularly if investors express a strong preference for dividends now, rather than later. Conversely, if the payout is cut it could also indicate that a firm is struggling and also hit the share price. But there are flaws in Gordon's argument. Some companies do not pay dividends, or their payout may be erratic, yet their price will rise if the market believes the prospects for the company, however long term, are good.

You will also recall that when a share sells ex-div, its price falls by the amount of the dividend. In other words, a dividend received is equivalent to a capital gain lost. But what if the two are not perfect economic substitutes, meaning they are not valued equally, even if the rate of income tax equals capital gains tax? Rational investors might prefer the expectation of larger future dividends, rather than smaller ones today; if they believe that the firm can retain and reinvest earnings in projects whose future profitability more than compensates them for the delay. In the interim, investors who cannot afford to wait always have the option of creating homemade dividends by selling their shares to gain the wealth amassed by management on their behalf, (Fisher's Separation Theorem op.cit).

As we observed in Chapter Four, since the 1960s an impressive body of research initiated by the seminal work of Modigliani and Miller (MM) also suggests that dividends may actually be irrelevant to share valuation. All that matters is the "bottom line", based on the riskiness of a firm's profitable investment and not how its earnings are "packaged" for distribution. In the absence of worthwhile projects, according to MM's hypothesis, the sole purpose of a dividend pay-out is the return of capital to shareholders that is surplus to the firm's future investment plans. In otherwords, a high dividend pay-out ratio signals management's failure to satisfy shareholder's expectations and not their success. A high yield can then suggest that share price has fallen and is expected to fall further, as investors sell the stock.

 
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