Focus on dividends, not growth

Why invest in the stockmarket? Most people buy shares in the expectation that they will get a modest dividend income and, more significantly, as the company grows, their capital will increase over time. This belief underlies the saving for retirement mantra promoted by fund managers and financial planners eager to increase their funds under management.

It is also the rationale behind the economic rule which says that the return from shares is equal to the dividend plus the rate at which the dividend grows. Most responsible analysts and economists assume when looking at the entire stockmarket, and over the long term, that dividends will grow as fast as profits which, in turn, grow as fast as the economy generally.

This sounds like good common sense and is the chief reason why high growth economies such as China, India and all the other emerging markets periodically jump on to investors' radar screens.

Alas, it is not quite that simple as the 2005 edition of the Global Investment Returns Yearbook (GIRY) points out. The GIRY is produced each year by three professors from the London Business School and is the leading source of long run data on shares, bonds, bills and exchange rates.

Significantly, the professors don't get trailing commissions from fund managers and their renumeration is not linked to the level of the Dow so they have no particular axe to grind.

This year's GIRY has data from 1900 to 2005 for 17 countries representing 92 per cent of the world's stockmarkets. New Zealand isn't in the study yet as local data only exists from about 1933 onwards but work is continuing to fill in the earlier years and 2006 could see our local market included as the 18th country in this most authoritative and comprehensive work.

The 2005 version of the GIRY looks at what connection there has been between economic growth and investment returns. There is a widespread view among investors, not to mention fund promoters, that the share prices of countries like China, Russia, India and Brazil do not adequately reflect the growth prospects of these markets.

So much for the belief, the reality can be quite different. The GIRY's long-term database shows that buying into a stockmarket that has a fast-growing economy has produced lower returns than the stockmarkets of a slower growth economy.

The professors suggest that by the time you read about the connection between high emerging market economic growth rates and company profits this information is likely to have already been factored into the share prices of these emerging market stocks so that, once it is clear that an economy is in a strong position and growing fast, it is too late to buy into that market. Their conclusion, unfortunately, is that, despite their high economic growth rates and low share prices, buying shares in India and China is probably not going to get you on the Rich List.

 

The professors draw a comparison with growth stocks and growth countries: just as growth shares underperform value stocks, stockmarket returns from growth economies tend to underperform that of lower growth economies. Japan has been an economic powerhouse in the last century: over 105 years Japan's economy grew by 3.6 per cent per year compared with Australia's 1.9 per cent, but Japanese dividends actually fell in real terms over the period and its stockmarket return was barely half that of Australia.

Investors got so excited about Japan in the early 80s that they bid prices up so high that, subsequently, Japanese shares underperformed.

A related problem with high share prices is that a firm's funding costs drop making all sorts of otherwise uneconomic projects look brilliant. The same thing happened with tech stocks and 3G in 1999. Will fund managers and financial planners be the only winners out of investing in China?

More generally, the stockmarket is popularly viewed as a growth machine but the professors' database shows otherwise: the size of the initial dividend has been a far more significant determinant of returns than the rate of dividend growth.

In 11 of the 17 countries in the good professors' database, dividends actually fell in real terms over the 105 years with an average increase of less than 1 per cent per year. The bulk of investors' historic returns came from dividends and an increase in the rating of the stockmarket rather than from growth in profits/dividends.

So what went wrong? Two US academics reckon the answer is that company management either wasted the money on silly acquisitions or, in countries with dodgy laws, took the money for themselves or their mates in the Government or the Army.

Either way, they reckon one dividend in the hand is worth two retained earnings in the bush.

This is particularly good news for New Zealanders as our dividend yield at around 6 per cent is high compared with the 2 per cent or so offered in the US.

The GIRY's message is, therefore, that equity investors wanting high returns from their share portfolios should probably ignore fund managers telling them to buy China, Russia or tech stocks in the US. Instead, the London Business School's research suggests mum and dad could do a lot worse than concentrate their funds closer to home in the high-yielding and lower cost stockmarkets of New Zealand and Australia.

* Brent Sheather is a Whakatane-based financial consultant.