How dividend growth can help boost portfolio returns

Many clients and advisers tend to think of income investing as a matter of finding the fund which offers the fattest yield and harvesting the dividends paid. But our research shows that it is consistent dividend growth that really matters when it comes to generating the best total returns from a portfolio of shares, at least if history is any guide, so depending on the client’s needs, picking an income fund that focusses on firms where the yield may be lower but the potential for payout growth is higher may be a strategy to consider.

Since its inception in 1962, the FTSE All-Share index has generated a compound annual growth rate of 6.8% a year.

If a client were to put a full allocation of £15,240 into an ISA and be able to bank that historic compound annual return for 20 years they would end up with £56,808 – although I must point out that figure is before adjustments for any dealing expenses or taxes.

That is pretty good going but the numbers look even better if both dividends and capital gains are added to the pot. If the same client were to also rake in the FTSE All-Share’s average historic 3.8% dividend yield on top of that 6.8% annual capital return and then reinvest those payments back into the market, the end result after 20 years would be £114,331, again before adjusting for any dealing expenses or taxes.

Dividends and their reinvestment can help to augment total portfolio returns

Source: Thomson Reuters Datastream. Assumes one initial full ISA allocation of £15,240 and no further contributions. Does not adjust for any dealing costs or taxes.

That is how income investing can be so powerful and the case becomes more compelling still once dividend growth is taken into account.

Dividend dynamos

History shows that the best total returns come from stocks which prove capable of consistently growing their dividends rather than simply knocking out a fat unchanged payment each year.

Over the past decade, 26 current members of the FTSE 100 have increased their shareholder dividend each and every single year.

The average share price gain from those 26 firms was 265.3% between 1 January 2006 and 31 December 2015, compared to a 9.2% advance from the FTSE 100 over the same time period.

All of the FTSE 100’s ten-year dividend growers beat the FTSE 100’s capital return between 2006 and 2015

Source: Thomson Reuters Datastream, Company accounts

On 1 January 2006, the 26 names were offering an average dividend yield of 2.8% between them, based on the dividend ultimately paid in 2006. At the time the 26 were offering a prospective dividend yield of just 2.8%.

Had clients known what dividends the 26 would offer in 2015, they may have been astounded (and delighted) to see that they were going to provide an average 9% yield, based on the 1 January 2006 share price and the actual dividend paid for last year.

Fund manager’s opportunity

This may all look simple, but unfortunately there is no such thing as a free lunch, and picking out ten-year dividend growers is not quite as easy as it sounds for two reasons:

  • First not all of the firms in the above list were in the FTSE 100 in 2006.
  • Second, the past is no guarantee for the future. Several firms which did have a proud history of dividend growth saw those runs end in 2015 and their share prices came a horrible cropper as a result. Pearson, Rio Tinto and BHP Billiton are just three examples.

Few if any advisers or clients will have time for the nitty-gritty of company research and poring over cash flow statements and balance sheets. This is where a good income fund manager has the scope to offer huge value to advisers and clients alike.

The table below shows the top five performing equity income OEICs over the past five years.

Top five performing UK Equity Income OEICs over the last five years

Source: Morningstar, for UK Equity Income category. Where more than one class of fund features only the best performer is listed.

The following table then lists their top 10 holdings according to their latest factsheets.

Top 10 holdings of top performing UK Equity Income funds

Source: Morningstar, for UK Equity Income category, fund factsheets.

The past is no guarantee for the future but note how the two best performers are currently focussing on mid-caps where there is potential for dividend – and capital – growth over time.

For younger clients, still seeking to grow their savings pot, these funds could provide a helpful combination of capital growth and income. Clients in drawdown may prefer to focus on those funds where high yielders predominate, perhaps even enhanced income funds, so they can take the income when they need it and perhaps focus a little more on capital preservation.

This column will return to the topic of enhanced income funds in the future but ultimately, what works best for them will be driven by their overall strategy, target returns, time horizon and appetite for risk.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.