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5 Important Things For Investors To Note About Dividends

There are really only two ways an investor can benefit from the stock market: A rise in prices (also known as capital appreciation) and the collection of dividends.

The former often grabs more attention (think of how much better you’d feel when you see the stock you bought at S$1 has risen to S$2), but the latter can be incredibly important as well when it comes to generating long-term wealth for you and me.

How important? Here’s something from my U.S. colleague Morgan Housel (prices for the S&P 500, a U.S. market index, are taken as of March 2011):

  • Current S&P 500 price: 1,319
  • S&P 500 in real terms, based on 1871 prices: 74.35
  • S&P 500 in real terms with dividends reinvested: 38,531
  • The power of dividends: Priceless.

As you can see, the simple act of reinvesting one’s dividends, for a long period of time, can make a tremendous – and positive – difference to one’s returns.

For those who are interested in investing for dividends, here are a few important things to keep in mind:

1. Focus on the track record

The past is not a perfect indicator of the future, but it can tell you a lot about what to expect for the years ahead.

A mutual fund in the U.S. (the equivalent of a unit trust here) called the GS Rising Dividend Growth Fund picks its stocks mainly through a simple checklist that aims to identify companies that have raised their annual dividends for a minimum of 10 consecutive years and by at least 10% per year on average. The fund has beaten the market – since its inception in March 2004, it has generated total returns of 9.04% per annum and has inched ahead of the selfsame figure of 8.24% for the S&P 500.

I’m not here to be an advocate for the Rising Dividend Growth Fund or its strategy. But its methods point out the importance (and usefulness) of looking at a firm’s track record with its dividends.

With this in mind, companies that could maintain or even grow their dividends through the Great Financial Crisis of 2007-09 might be a good place to start when looking for candidates for further research. The aptly-named Hong Kong-based real estate investor and developer Hongkong Land Holdings Limited (SGX: H78) is one such share in our local market.

Hongkong Land dividend history

Source: S&P Capital IQ

As the table above shows, it has displayed an admirable track record in growing its dividends over the past decade.

2. Cash is king

Dividends are ultimately paid using the cash that a company has and a good way to gauge a firm’s ability to maintain its dividend is thus the ratio of its dividends to its free cash flow.

There are no hard and fast rules as to what makes for a good ratio, but the basic idea is that the lower the number is, the more room for error a company has. And given the inherent volatility in the business and economic environment, it’s always nice to have some margin of safety in place.

Dividend to free cash flow (FCF) ratio for Straco and Vicom

Source: S&P Capital IQ

Some good examples of companies in Singapore with a history of having a low dividend-to-free-cash-flow ratio could be Straco Corporation Ltd (SGX: S85) and Vicom Limited (SGX: D01). You can see their track record in this regard in the chart above.

3. Cash is king – Part 2

Strong balance sheets that are flush with cash and have minimal or no debt can help protect a company’s dividends in the event of an economic winter.

But that’s not all – a rock-solid balance sheet gives a company optionality. In the event of an economic crash, companies that are not shackled by heavy debt-loads can go on the offensive and gain market share at the expense of weaker competitors, in the process building the foundation for even higher dividends in the future.

Cash, and the possession of it, is a beautiful thing when it comes to dividend investing.

4. Beware high yields

All things being equal, a high dividend yield is favoured over a low one as the former can provide an immediate and sizeable stream of income.

But, all things are not equal in the real world. In reality, a high dividend yield can be a canary in the coal mine, a sign that investors would need to dig deeper into a share’s business. That’s because high yields often come with low valuations, and shares with low valuations are often companies with low-quality businesses that can’t grow or are plagued by problems.

Our job as an investor is to figure out the quality of the company’s business and, if it’s facing issues, judge if those problems are permanent or temporary.

5. Reinvest those dividends

I’ve showed you the power of reinvested dividends earlier on in this article. Here’re even more examples using local companies Jardine Matheson Holdings Limited  (SGX: J36) and Starhub Ltd (SGX: CC3).

Jardine Matheson and Starhub's historical returns

Source: S&P Capital IQ

As you can see in the table above, the difference between the capital gains of the two shares and their total returns is massive even when we’re measuring returns over just a decade.

It can be difficult for us to reinvest our dividends manually here in Singapore (given issues like the compulsory need to buy stock in lots of 100 shares each), but there are some companies, like Raffles Medical Group Ltd (SGX: R01), for instance, that allow shareholders to choose to receive their dividends in newly-issued shares rather than cash. Such schemes can be a good proxy for the actual reinvestment of one’s dividends.

A Fool’s take

Dividends can make a world of difference to our investing experience and returns. Don’t lose sight of them – and keep in mind the important points above when you’re looking at those precious payouts.

For more analyses on dividend investing and important updates about the stock market, sign up to The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Straco Corporation, Vicom, and Raffles Medical Group.