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Dreaming of dividends

Recent meetings at Martin Currie have focused on the big issues of our times – stagflation, monetary policy, banking crisis and recession. I often find that my mind is wandering and my eyes are staring out of the window. When that happens, I try and focus on what really matters for investors. No matter what the topic of discussion, my colleagues know what I am thinking about – dividends.

If one of my colleagues happens to mention that they have noticed something interesting about a company I am not familiar with, I will listen. If a global sector manager starts enthusing about a stock, I will take notice. I might even wonder if I can make room for it in my portfolio. Until, that is, they mention that this company does not pay a dividend. My interest ends at that point.

You might wonder what comfort a dividend cheque is, when slowing growth and rising inflation are wiping billions of pounds off the value of the market. You might ask why dividends interest me so much, when the UK’s biggest banks are asking their shareholders for billions of pounds. Dividends matter because, irrespective of where we are in the market cycle, it is almost impossible to overstate their importance to long-term equity returns.

The correlation between long-term returns and rising dividends is so strong, and the proportion of long-term real returns that dividends account for is so big, that my approach starts and ends with dividends. Right now, dividends matter more than ever, offering a useful corrective to some of the current pessimism.

The forecast dividend yield on the UK market is hovering at a very healthy 4.5 per cent and the prospective yield on my portfolio at the end of last month was 5.3 per cent. That is more than the yield on 10-year gilts. This is a rare occurrence and has historically been predictive of excellent returns to come.

The UK market has been a tough place to invest this past year but these measures indicate that it is attractively priced. Recent panic selling has been understandable. It can be hard to remain calm when most of Britain’s high-street lenders seem to be self-destructing and house prices face collapse. Buying equities when the market is in freefall takes courage, a cool head and good timing. Looking at the dividend yield relative to gilt yields is one way to help your timing. A good way to keep a cool head, meanwhile, is to deconstruct predicted dividend growth. One analysis of UK dividend prospects that we performed recently showed that even in a worst-case scenario, there will be 5 per cent dividend growth by UK firms this year and next.

That was not a function of over-optimism on our part. In performing this analysis, we anticipated a 20 per cent reduction in dividends from the banking sector. We still expect to see above-inflation dividend growth from UK companies. That is not a comfort available to bond investors, who will see their capital eroded as inflation works its way through the global and UK economies.

If you are willing to accept that the UK market is more attractive than you might have thought, where should you invest. In a tracker fund? No. Now, more than ever, a selective approach is called for. News on the housing market and in the banking sector remains dire. More firms in those areas will see earnings’ downgrades and issue profit warnings. Investors must discriminate between stocks that have been deservedly derated and those that have been unfairly caught up in panic selling. If they do that, the rewards will be significant. Oil prices have started to fall and the one-way bet on commodities is no longer a sure thing. Share prices in previously maligned parts of the market have started to recover and there are signs that investors are looking at stocks that have been hit hard but may prove long-term bargains.

I have been selectively increasing my holdings in industrials and financials. It is time to stay calm, stay selective and grab those high dividends while stocks last.

Scott McKenzie is manager of the Martin Currie UK equity income fund


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