Dividends: the forgotten story

As far as the share market is concerned, everyone talks about the tail and fails to notice the dog.

The dog in this case is growth of dividends and the tail is growth of share prices.

The Australian Stock Exchange (ASX) price index is reported daily in every medium, yet this is only half the story. It’s important for investors and advisers to remember that returns consist of both capital growth and income (that is, dividends), but the progress of dividends is rarely focused on.

Key facts

> Dividends (including franking credits) have grown prolifically since December 1919. By the end of 2006 dividends had increased 246 times, while prices had increased 247 times.

> Dividends have been significantly less volatile than capital. Between December 1919 and December 2006, the standard deviation of capital was 16.2 per cent per annum versus 7.9 per cent per annum for income.

> Income has proven to be remarkably resilient during market downturns. On average since December 1919, income has fallen 17.5 per cent less than capital during calendar years in which prices fell.

> Income growth has not occurred without the occasional stumble. On average, dividends have fallen approximately every 12 years. Falls have often coincided with economic downturns.

> The past 15 years have been aberrantly prosperous in terms of the high growth and low volatility displayed by real income. Since December 1919, there has not been a comparable period. This has coincided with uninterrupted economic prosperity. Probability suggests that the next 15 years will not be as prosperous.

Despite the occasional stumble, the Australian share market has proven to be a fertile source of steady, growing dividends. Long-term investors should focus on the growing income stream and let growth take care of itself. Graph 1 (page 28 of Money Management, June 28) illustrates the close relationship between these two factors.

Notwithstanding the long-term linkage between income and growth, the latter is much more volatile in the short term. This is particularly evident during market downturns.

Graph 2 (page 28 of Money Management, June 28) illustrates the 25 largest calendar year share market price falls. The corresponding change in income is also included.

Although there have been exceptions (for example, 1962), income has proven to be remarkably resilient. For example, in 1974 capital fell by 30.9 per cent while income actually increased by 14.9 per cent. During all calendar years in which there was a share market decline, income fell by 17.5 per cent less than capital, on average.

This does not mean income is immune from all volatility.

Graph 1 also highlights falls in income of more than 3 per cent over at least one year. It shows that income growth has not occurred in a linear fashion.

On average, dividends have fallen approximately every 12 years, often during recessions. Extreme negative movement occurred in the early 1930s (-46 per cent) and in the early 1990s (-33 per cent). Both of these coincided with economic downturns.

It is no coincidence that during the past 15 years dividends have displayed high growth and low volatility. To test how representative this period has been, Centric Wealth compared it with all other periods of comparable length.

Graph 3 (page 28 of Money Management, June 28) illustrates the volatility of income versus the growth in income in inflation-adjusted terms, over rolling 15-year periods. Low volatility and high growth in income is indicated by observations that fall in the top left quadrant of the chart. In risk-adjusted terms, 1991-2006 was the most prosperous period ever.

The next 15 years are unlikely to be as promising. We say this because history shows that dividends have a tendency to oscillate broadly around their trend.

Currently, the Australian market is trading on a yield of around 4.8 per cent (including franking), but this is based on a dividend that is 80 per cent above its long-term real trend.

It goes without saying that, despite the many virtues of dividends explored in this article, any reversion towards their long-term trend could pose challenges to current share prices.

Methodology

The period relates from December 31, 1919, to December 31, 2006, with quarterly instances observed. Since June 1987, the raw data has been grossed-up to account for franking credits. For simplicity, we have assumed a company tax rate of 30 per cent and 80 per cent franking throughout. (Sources: Centric, ABS, ASX, RBA.)

James Foot is the head of non-listed research at Centric Wealth .