Why dividends reward investors through good times and bad

It is possible to generate income of 5% a year from a portfolio of dividend stocks

Most investors reinvest dividends back into their portfolio to generate more growth. Getty

Stock market growth has been hard to come by over the past 18 months, but there’s a bright spot for passive income seekers as company dividends have been booming.

Dividends are the regular quarterly or half-yearly payments that companies make to reward shareholders for their loyalty and, in some cases, to compensate for a lack of growth prospects.

They are typically served up by big solid blue-chip companies, although some smaller firms also pay them.

While the business headlines focus on whether share prices are rising or falling, long-term investors know that dividends will reward them through good times and bad.

It’s possible to generate income of, say, 5 per cent a year from a portfolio of dividend stocks, with any capital growth and rising share prices on top of that.

Global dividends are on the up, with their total value jumping 12 per cent to a record $326.7 billion in the first three months of this year, according to the latest Janus Henderson Global Dividend Index.

Despite today’s economic uncertainty, 95 per cent of companies either increased their dividends or held them steady, providing some compensation for last year’s stock market troubles.

Janus Henderson has now upgraded its dividend forecast for all of 2023 to $1.64 trillion, a rise of 5.2 per cent on 2022.

This year’s strong dividend growth is all the more impressive given last year’s high inflation, rising interest rates, geopolitical conflict and continuing Covid lockdowns, says Ben Lofthouse, head of global equity income at Janus Henderson.

“Profits were nonetheless strong last year and this has supported further dividend growth,” he adds.

Many novice investors underestimate the power of dividends, which amplify the total returns from the stock market.

Most investors reinvest their payouts back into their portfolio to generate more growth while of working age, then start drawing them as income after they retire.

Dividends are not guaranteed, unlike the interest rate on a cash savings account, and can be cut or scrapped at any time if a company is short of cash.

However, directors aim to increase them steadily year after year, giving investors an income stream that rises over time.

The UK’s FTSE 100 offers some of the most generous dividends in the world, with stocks listed on the index yielding 3.7 per cent on average today, against 1.64 per cent on the US S&P 500.

This more than makes up for the FTSE 100’s lacklustre performance.

At the time of writing, the index was trading at 7,560, just 9 per cent higher than December 31, 1999, when it ended the millennium at 6,930.

Despite that sluggish performance, the index has still delivered an average annual return of 6.89 per cent a year over the past two decades, once reinvested dividends are added to the tally.

Some FTSE stocks have super high income levels right now, with insurer Aviva yielding 7.75 per cent, British American Tobacco yielding 8.18 per cent and Vodafone Group paying income of 9.55 per cent a year.

Yet, a high yield can often be a sign of an underperforming stock.

Yields are calculated by dividing the dividend per share by the share price, so when a stock falls, the yield automatically rises.

Once a yield nears double digits, it can quickly become unsustainable.

US payouts have also hit a record, according to Janus Henderson, with real estate, technology and healthcare sectors the largest contributors to dividend growth.

European companies also upped their shareholder payouts smartly, with Denmark, Germany and Switzerland accounting for three quarters of the total.

Banks and oil companies are likely to continue increasing their dividends this year, while the mining sector may struggle, Mr Lofthouse says.

While dividend growth is likely to slow as “almost all the easy gains from the post-pandemic bounce-back have now been made”, they will remain much less volatile than company earnings over time, he adds.

Investing in dividend-paying stocks offer investors several benefits, of which the most obvious is a regular stream of income, says Vijay Valecha, chief investment officer at Century Financial.

“Dividend-payers tend to be more established and financially stable, as they generate consistent profits to distribute to shareholders.”

Dividends can also act as a buffer during market downturns.

“Even when stock prices decline, companies that continue to pay dividends provide some level of stability. Plus they also offer inflation protection,” Mr Valecha says.

Investing in individual dividend stocks can help to maximise yields, but it is also risky and most investors prefer to diversify through a low-cost exchange-traded fund.

The iShares UK Dividend UCITS ETF tracks the performance of 50 high-yielding UK stocks, with British American Tobacco, Rio Tinto, Vodafone and HSBC its top four holdings, Mr Valecha says.

“It also contains miners, banks and several defensive stocks with a reliable history of dividend payouts, with a current yield of 6.21 per cent.”

For those who want a wider geographical spread, he highlights the Fidelity Global Quality Income UCITS ETF.

“This tracks the performance of large and medium-sized dividend-paying companies from developed countries and offers an indicated dividend yield of 4.63 per cent.”

There are a number of other global dividend ETFs, including Vanguard International High Dividend Yield ETF, which yields 4.4 per cent from stocks such as Shell, Roche Holding, Novartis, Toyota, Royal Bank of Canada and Siemens.

Other high-dividend ETFs to consider include the US-focused SPDR Portfolio S&P 500 High Dividend ETF, which currently yields 4.83 per cent a year.

The Global X SuperDividend ETF invests in 100 of the highest dividend-paying equities around the world. It currently yields 12 per cent, which looks thrilling, but comes with added risk, with the fund’s net asset value actually falling by 20.71 per cent since launch in August 2008.

Corporate culture has evolved and returning dividends to shareholders is now common all over the world, says Darius McDermott, managing director of FundCalibre.

“The highest dividend yields come from the UK and Asia. It's pretty standard to get 4 per cent or 5 per cent from funds investing in these areas.”

Yet, he says that dividends aren’t the only way to generate investment income.

“Personally, I'd look to achieve this through a diversified portfolio of equities, bonds, alternatives and even a bit of cash. That way, as well as generating an income, hopefully you'll get some capital growth, too.”

Mr McDermott says bonds are back on the table as interest rates increase.

“Investors can now get decent yields on less risky areas like US Treasuries and investment-grade corporate bonds. What’s more, when interest rates start to fall, you’ll enjoy capital gains as the value of your underlying bond holdings rises, too.”

There are some great dividend-yielding stocks out there right now, but approach those super-high yielders with caution.