DIVIDENDS do not get the respect they deserve. Over the long run they provide the bulk of equity investors' returns. Work by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School* found that over the period from 1900 to 2005, the real return from global equities averaged 5%. The mean dividend yield over that period was 4.5%.

Despite this, stockmarkets devote a lot more time to forecasting and analysing profits than they do to thinking about payouts. Profits can be easily manipulated and come in a bewildering variety of forms (operating, reported, post-tax, pre-exceptional, etc). Dividends are (mostly) paid in cash and so are hard to fake.

In America dividends seemed to go out of fashion in the 1990s. A yield of 2% or so appeared trivial when the market was rising by 20% a year. The disrespect for dividends also reflected the belief that, for tax reasons, share repurchases were a better way of returning cash to investors. But share repurchases are much more volatile than dividend payouts and were briefly negative in 2008 (firms issued more shares than they bought back). Dropping a buy-back programme can be done on the quiet. A dividend cut is a very public statement of corporate weakness.

So what do current dividend levels tell us? First, the bad news. The global yield, as measured by the FTSE Global AllCap index, is only 2.5%. That suggests a very low level of future real returns from equities. Those returns have three components: the current level of dividend yield, real dividend growth and changes in valuation (moves in dividend-price ratios).

Perhaps surprisingly, Messrs Dimson, Marsh and Staunton show that, equally weighted, the average equity market enjoyed no real dividend growth at all over the 1900-2005 period. America performed better than most, achieving 1.3% annual growth. Thanks to Wall Street's heavy weighting in the world index, this dragged up the global dividend increase to 0.8% a year. But this figure falls well short of GDP growth. If repeated, it would raise the real equity return to just 3.3%.

As for valuation, this contributed around 0.7% a year to global equity returns between 1900 to 2005. In other words, share prices rose faster than dividends, and the yield fell. With the yield well below the historic average it seems implausible to assume any further contribution from valuation. Indeed, changes in valuation may subtract from future returns.

There is, however, some good news. The modern fashion for creating derivatives means that it is possible to gauge investors' expectations about future dividend growth. Dividend swaps allow investors to separate the income from the capital return of equities.

A very gloomy view for European payouts, at least, has already been absorbed in the price. According to James Montier of GMO, a fund-management group, investors are expecting no growth at all in European nominal dividends between now and 2019. That looks unlikely. Even America managed to generate some dividend growth during the Depression.

Mr Montier adds that European corporate dividends have already dropped by 33%. In the past dividend declines of such magnitude have been followed by annual gains of 5% over the subsequent decade. Even a dividend growth rate of 2% would make the swaps good value, in Mr Montier's view.

In the context of the London Business School study, however, investors may be taking a rational view of the dividend outlook. If real dividends barely grow over the long term, then a forecast of stagnant nominal dividends may simply reflect investors' expectations of zero inflation. That low-inflation outlook is indicated by the level of core European bond yields.

Such low bond yields do give the equity bulls one more (fairly powerful) argument—that dividend yields look good by comparison. Germany's equities yield 2.9% and its ten-year bonds yield just 2.1%. Equities yield more than government bonds in Britain as well. Even if dividends did turn out to be stagnant for the next decade, investors would still get a higher income from equities than from government bonds. And if by any chance inflation were to take off, dividends would rise whereas government bonds would look horribly overpriced. The prospect for equities may not be great, in other words—but they may still be the best of a bad lot.





* “The Worldwide Equity Premium: A Smaller Puzzle” by Elroy Dimson, Paul Marsh and Mike Staunton

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