In short, dividends matter. Over the past 25 years, almost half of the total return (the combination of capital growth and income) from US equities has been derived from reinvested dividends and their compounding effect. The S&P 500 Index has generated an annualised total return of 7.4% during that timeframe, with 55% from price appreciation and 45% from the reinvestment of income. (Source: Bloomberg, 30 April 2024).
The benefit of a growing income
The appeal of equity income compared to cash, is that dividends can grow, in our view. Investors have embraced cash as yields have increased but these may be fleeting. Cash rates may well decline over the next 12 months, which could prompt income-seeking investors to revert to equity income. In this situation, dividends become even more appealing because they could provide a growing income stream and increased cashflows.
We believe this has two major attractions. First, it can offer protection against inflation. Rising prices eat away at investors’ wealth but investing in companies that provide a growing dividend can mitigate this. Interest rates that look attractive today may not be that compelling in future years. However, identifying companies that have the business model, assets and strategy to grow consistently and deliver rising dividends is potentially more compelling over a long-term horizon than a short-term, higher yield offering.
The power of compounding
This brings us to the second feature of dividend investing: Compounding. Albert Einstein is said to have described compound interest as the eighth wonder of the world. Dividend growth is a strategy with a tailwind: The reinvestment of growing dividends can be a highly effective way of generating wealth over the long-term, in our view.