Opinion Divided On Dividends

By David McEwen

Monday 5th November 2001

New Zealand companies have been criticised for paying larger dividends than their international counterparts.

This has been blamed for the low growth over many years in the local market when compared with overseas ones.

However, with the slump in prices on many markets in the past 18 months, and high volatility in recent weeks, investors are realising that dividends have their benefits. As one British commentator put it recently, "Over the past 18 months, companies paying large dividends have massively outperformed the rest of the market. People are belatedly waking up to the fact that dividends matter".

One of the reasons dividends are returning to favour is that they provide income at a time when share prices cannot be relied upon to deliver profits. An investor receiving income can better afford to sit tight and wait for market conditions to improve.

However, those dividend cheques need to be treated with respect. All too often, people treat them like a windfall and spend the proceeds on consumer items. To make serious money from the share market, investors need to reinvest those dividends.

This can be seen from a recent study of the US share market.

This found that if someone had invested $US10 in the market in 1800 (a decent sum in those days) and their descendents had reinvested all dividends, the portfolio would now be worth $US3.4 million after adjusting for inflation.

However, if those dividends had been spent along the way, the portfolio would be worth a mere $US200.

Considering this, it seems strange that sentiment has been against dividends in the past couple of decades.

In the US, the average dividend yield has declined from around 7% in 1982 to a little over 1.5%. In New Zealand the average is still around 6.5%.

While strong share price growth has contributed to the low yields, US companies have also been paying out less in dividends than they were 20 years ago, by around 40%.

One of the main reasons for this has been a preference for returning money through share buybacks.

These are supposed to produce tax-efficient benefits to shareholders by delivering share price growth instead of dividends.

Firstly, if shares are removed from circulation through a buy back, then the asset and earnings per share figures rise. In theory, this should lead to the remaining shares going up in value.

Also, if a company paid out less in share buybacks than it had been paying in dividends, then it could retain the balance for reinvestment. This would create more profits and push up the share price even higher.

Unfortunately, it has not always worked that way.

Share prices can be volatile and companies embarking on a share buyback sometimes end up paying inflated prices. On some occasions, the sheer volume of shares being purchased helped drive up the price.

This has resulted in some shareholders seeing the value of their shares decline, without any dividends to relieve the pain.

Another benefit of dividends is that they offer an easy way for investors to assess the strength of a company.

A cut in dividends is often a warning sign and one that no shareholder is likely to miss. However, a scale back or suspension of a share buyback programme is more likely to go unnoticed.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz or by mail care of this newspaper.

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