With companies announcing cash dividends, investors might be wondering if it's good idea to put the money back into the stocks.
Yes, it is. In fact, investors, especially from the developed world, feel it's better to focus on income rather than growth in these times of uncertainty and volatility. Depressed returns from equities and low interest rates on cash and government bonds in the last few years have led to increased focus on high-yield dividend stocks.
Studies have shown that dividend reinvestment has a significant impact on long-term returns, assuming the payouts are sustainable, regular and the stock price does not suffer a devastating decline. Typically, these are large cap value stocks of the likes of Procter & Gamble, Unilever, Coca Cola, Chevron and GlaxoSmithKline.
"Equity income investing is not just about receiving the income, but reinvesting the income received and allowing the power of compounding to drive their total return," says Dan Dowding, senior executive officer, Killik and Co, Middle East and Asia.
"Compounding is all about time," says Vince Truong, certified financial planner at Holborn Assets. "So, the more time that is invested, the compounding [effect] is that much greater."
Barclays study
The Barclays Equity Gilt 2011 study shows that £100 (Dh576.76) invested at the end of 1945 would now be worth £227 in real terms without the reinvestment of dividend. With it, the total amount would have grown more than 17 times to £4,027. Looking at the US market, $100 (Dh367) at the end of 1925 would now be worth $23,748 and $732 in real terms, with and without reinvestment of income respectively.
"Income investing is about building portfolios," says Dowding. "The powerful combination of dividend yield and dividend growth can produce above market average returns."
A study by the French bank, Societe Generale, shows that over a one-year period, 62.4 per cent of the return is driven by a change in valuation, 11.1 per cent is driven by real dividend growth and 26.5 per cent is driven by dividend yield. Over five years, 18.3 per cent of the return is driven by a change in valuation, 34.7 per cent is driven by real dividend growth and 47 per cent is driven by the dividend yield.
Also, as Shakeel Sarwar, head of asset management at investment bank Securities and Investment Company (Sico), Bahrain, points out, historically total return on equities, which assumes that cash dividends paid is reinvested in more shares, have beaten inflation over long periods of time.
"Investors that choose to reinvest will undoubtedly benefit from compounding their returns which over the longer term adds significantly to value," says Saleem Khokhar, head of equities at National Bank of Abu Dhabi's (NBAD) asset management group.
However, Khokhar points out, many investors also require a regular income stream and a high dividend-yielding portfolio satisfies both objectives.
"Many investors can and do employ leverage and a high dividend-yielding portfolio in this instance will cover the cost of leverage and still leave some cash flow that can be reinvested or withdrawn."
Sarwar adds that there is also the benefit that comes when cash dividends are taxed at a higher rate than capital gains: if dividends are invested back into stocks, the investor benefits from the lower capital gains tax rate. However, in countries such as GCC where there's no tax on dividends, except in Kuwait, this benefit is not material.
In general though for any long-term investor, some allocation towards large cap value stocks are a permanent part of any portfolio, says Truong.
"The question is what percentage goes to it and what percentage goes to other asset classes or to growth stocks," he adds.
Cherrypick stocks
At present, market corporate dividend yields are quite attractive, says Krishnan Ramachandran, chief executive of Barjeel Geojit Securities, Dubai. He believes now is a good time to cherrypick stocks and favourably consider reinvesting dividends and periodically adding to investments.
"This methodology will, in the long term, deliver a better rate of return to the investor," says Ramachandran. "The caveat, however, will be how the markets behave. In case of sharp upward rally, as being witnessed now, yields will tend to drop and stock appreciation will become more attractive."
It would, in fact, be unwise to discount the risks of focusing solely on high dividend yield, says Dowding.
"A dividend yield can appear high (albeit temporarily) when a company becomes distressed," he says. "The combination of a falling share price paired with a historical dividend payment can create an attractive illusion. This illusion tends to be the most dangerous around periods of economic crisis. It is for this reason that dividends must be considered in the context of a business' ability to sustain and pay that dividend into the future."
Eroding fundamentals
If fundamentals deteriorate or if dividends fall below expectation, automatic reinvestment in the same stock or continuing to hold the same share may hurt returns, says Khokhar.
"We at NBAD rebalance such portfolios on a quarterly basis after assessment of quarterly results to ensure portfolios continue to be optimally positioned," he says. "You can expect such a portfolio to have a turnover of 100 per cent an annum. Reinvestment of dividends received in such a scenario ensures consistent dividend payments and continuous compounding."
In current volatile times, investors should look at dividend reinvestment from a two to three-year perspective rather than a longer-time horizon, Ramachandran says.
"It will be prudent to review and change for better growth options as part of their overall portfolio allocation," he advises. He also points out that investors have the option to invest in equity income mutual funds, rather than take the risks associated with investing directly in stocks.
Taking the form of dollar-cost averaging
Some of the dividend plays favoured by investors in the UAE include etisalat, Air Arabia, First Gulf Bank, Taqa (Abu Dhabi National Energy Co.), Abu Dhabi Islamic Bank and Emaar, to name a few. But, even among these, dividends have not always been consistent and regular.
In the US, Dividend Re-Investment Plans (DRIP) automatically converts dividends into company's stocks. In the UAE and Gulf or for that in many matter emerging markets, investors have to take the dividends and go into the market to re-invest in the stocks themselves. However, commission charges can impact negatively on the return.
Reinvesting dividend income is like dollar cost averaging: where an investor systematically accumulates dividend paying stocks a few times a year. More shares are bought when the price is lower and less when it is higher, says Krishnan Ramachandran, chief executive of Barjeel Geojit Securities, Dubai.
