Dividends vs growth: It's a balancing act

Are equity investors approaching a bubble scenario in terms of yields? The flight to dividend-paying shares over the last few years has pushed underlying stock values to the point where a correction could result in a sharp reduction of capital values of income-producing shares.

In the past few years we have seen a major shift toward investing for dividends rather than capital appreciation. Leading the charge have been growth-hungry stockholders who were frustrated because they could not achieve high capital appreciation. Those who were really interested only in growth on their principal prior to the 2008-09 recession have clearly shifted towards securing steady yields from stocks since then. The result is that income distributions make the overall gains on equity investments acceptable in percentage terms.

In the past five years the world has become a low-rate marketplace and the lust for higher yields has grown ever more intense. With capital growth in many sectors as low as it has been in a while, investors have been ignoring the possibilities of great growth deals in favour of steady income in order to satisfy their requirements. Capital protection has become more of a desire as long as income can also be sustained.

It is usually commonplace for bonds to be a safe haven while at the same time producing acceptable yields. But central banks have held interest rates very low and rates on fixed investments such as bank deposits have been so low that equity earnings have delivered the best value.

Equity markets this year have surged, which in turn has depreciated the dividend yield rates afforded to investors. Actual dollar dividend values have not really changed, but as a percentage of the value of the shares they relate to, rates have declined. This has been exaggerated of late.

The S&P 500 index has a history reflecting yields as high as almost 14% in 1932 and as low as 1.11% in 2000. The average is currently accepted as being between 2.5% and 5.5%. The overall dividend yield rate for the FTSE averages between 3% and 5%. You may be invested in some equities that have been producing higher dividend payouts than this in percentage of their share values. However, as the shares begin to increase in capital value, the dividends shrink in percentage terms of that capital value. This is known as yield compression.

Some will be unconcerned about a yield bubble. If dividends are constant, no matter what their percentage of share value, why worry if you are not depending on capital growth value? The fact remains that all investors tend to be subjective about the realities of their holdings. Even when dividends are good, investors become concerned when capital values decline.

It is also worthwhile to note that retained gains actually matter to investors because actual losses are very difficult to recover. Thus the realities of market fluctuations, in terms of dividend and capital values, must be balanced and carefully considered in any portfolio.

The current 3.3% yield on the FTSE still looks great compared to most fixed-rate investments. However, if the index surges a further 10%, things will change and there could be a sharp exit from the market because dividends are no longer attractive, while substantial gains have been made on the principal investment. This could create a sharp drop in share values, meaning the yield bubble will have burst.

Perhaps you need to decide now whether you feel dividend income is a good balance against a capital value reduction. One obvious choice is to sell your shares. This way you will capture the recent capital gains. With retained gains you would be in a position to buy back into the market when prices drop.

But suppose the markets do not drop and you have "sold" your dividend-producing holdings? Where will that leave you?

The opposite decision is to retain your shares and continue receiving the income. In this situation most investors will be wise to ask themselves, "How do I see equity values in, say, five years from now?" Most will agree that based on history they will be higher than today. A decision to stay in may thus be wise.

Do you have the nerves to ride through these types of situations, which can last for long periods of months and years? Perhaps the best way forward would be to use the collective system of investment funds?

If you have a personal portfolio in which you have chosen the stocks you hold, the chances are you have not spread your risk sufficiently across the available holdings. The vast majority of investors become subjective about their portfolios and often miss opportunities that they know are sensible, but they have emotional thoughts about the companies they hold.

Two of the best ways for expat investors to use markets is by purchasing mutual funds and/or index trackers to collectively spread their risk. These are often viewed differently by investors. An index tracker will simply invest in every equity in the index to be followed. If you invest in the FTSE 100 you will hold shares in each of the companies listed on the index. This allows you to benefit from the collective capital gains of the index overall. One downside is that there are usually no dividends paid on index trackers.

Mutual funds will be managed by an expert who will buy and sell different companies listed in his area of specialty. Thus a mutual fund investing in UK equities will buy the shares the manager predicts will go up in value and pay dividends in an attempt to give investors an overall higher return than the index.

Some funds specialise in income stocks. This means that they manage in the areas where companies are paying dividends and you have the choice to either reinvest your dividends into more stocks in the fund or receive them in cash. The trick here is that the fund manager is very objective about the strategy and tries to trade in and out of stocks to ensure that you not only make the most of dividends but also make gains on capital.

The type of fund chosen is often the subject of debate and many argue that index trackers have cheaper charges. While this is true if you are investing in an overall index rather than individual equities, you may be missing out on opportunities. For example, in 2012 the FTSE 100 index rose a mere 3.47%, while the best managed equity fund in 2012 made a 44% overall gain. If you choose the wrong fund to invest in, you may well be worse off than the index tracker. However, a fund manager picks his moves and has the opportunity to make more gains for the investors he represents.

No matter how you look at it, there is no correct answer. There are many factors to consider when investing today and even the best experts get it wrong. Maybe you are better off with a bank deposit paying you 2.5% with apparent capital protection. Better make sure you are not with another Lehman or any of the Icelandic banks that collapsed and left investors with virtually nothing. But then again, how do we know who these are?

Andrew Wood has been an expat in Asia for 33 years and is executive director of PFS International. His articles, which cover the complete A-Z of financial planning, are available through the PFS library to readers on request. Questions to the author can be directed to PFS International on 02-653-1971 or emailed to enquiriesthailand@fsplatinum.com.

About the author

Writer: Andrew Wood
Position: Writer