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Investing in dividends for growth

High yield stocks have doubled the return of low yield stocks over 20 years. This applies across large cap, mid cap and small cap stocks. The FTSE 100 index at a record high. Why high yield stocks have prospered Income funds for long term growth. Article from Hargreaves Lansdown.

Global dividends hit a record high of $1.2 trillion in 2014, according to the Henderson Global Dividend Index, released. Dividend paying stocks are naturally popular with income-seeking investors, but our analysis shows they should be prized by growth investors too.

Meanwhile on Friday 13th February, the FTSE 100 reached a record high, if you take account of the dividends paid by the big blue chip firms. Laith Khalaf, Senior Analyst, Hargreaves Lansdown: ‘Growth investors shouldn’t fall into the trap of thinking income funds are just a boring investment used by pensioners to boost their income. As we know the tortoise beats the hare in a foot-race, and likewise one of the best routes to long term growth is through harvesting dividends and re-investing them. Equity income funds do just that, often with lower volatility than the rest of the market. These funds should be considered by even the youngest investors in Junior ISAs and SIPPs as a building block for future growth, as well as retired savers looking for extra income from their investments.’

High yield stocks outperform low yield stocks

High yield UK stocks have more than doubled the return of their low yield counterparts over the last 20 years. This is irrespective of the size of the company, as can be seen from the table below, which shows the return from the highest and lowest yielding stocks in the UK market.

                                         HL low yield index                         HL high yield index
 
All UK                               192 percent                                        532 percent
 
Small                                43 percent                                          830 percent
 
Medium                           340 percent                                        812 percent
 
Large                               187 percent                                        532 percent
 
 
(31st Dec 1994 to 31st December 2014- total return, dividends reinvested. HL yield indices defined as the top and bottom 50 percent of yielders by market cap, rebalanced quarterly).There are times when low yield stocks have streaked ahead of high yield stocks- during the tech boom for instance, but these figures suggest that over time the tortoise-like dividend payers ultimately overtake the hares.

 

FTSE 100 hits record high

The FTSE 100 total return index hit a record high on Friday, closing at 5,204. If you’re kicking yourself for missing it, don’t worry- everyone is. That’s because the headline FTSE 100 Index we all regularly obsess over still stands below its December 1999 peak. But once you include the dividends paid by FTSE 100 stocks, as of Friday 13th, the total return index is 66 percent above its December 1999 level. This index has regularly reached record highs, indeed the previous high was achieved only two weeks ago. This illustrates how important dividends are to stock market returns. Laith Khalaf, Senior Analyst, Hargreaves Lansdown: ‘It’s the FTSE Jim, but not as we know it. The main FTSE 100 index has unquestionably become the barometer of the UK stock market, but it misses one vital component- dividends. The importance of dividends should not be underestimated, and an index which includes them better portrays the fortunes of the UK stock market investor.  Fortunately FTSE also publish a total return version of the 100 index, which is largely ignored on a day to day basis. With dividends included, this index stands over 60 percent ahead of is December 1999 level, when the main price index hit an all-time high. This tells us in a nutshell what a huge difference re-invested dividends can have on a portfolio.’

Why do high yield stocks do better?

There are a number of explanations for the outperformance of high yielders. The simplest explanation is the power of compounded dividends. Even if you take a 3 percent dividend yield and reinvest it each year, you end up doubling your money in 23 years, before even factoring in any capital or dividend growth from the companies you’re investing in. The dividend yield is an indication of the value of a stock. A high dividend yield suggests a stock’s price may be lower than the rest of the market when compared to the income stream it is generating. This is why a ‘yield discipline’ can help fund managers to outperform- by buying stocks at a high yield and selling them at a low yield,to buy low and sell high, with profits continually being recycled into more undervalued areas. Companies that pay high dividends tend to be more robust and focused on feeding cash through to shareholders. Meanwhile plenty of small, exciting growth companies that don’t pay a dividend ultimately fail. There are certainly opportunities amongst this latter type of stock, but they need to be picked out selectively. This perhaps goes some way to explaining the huge differential between the performance of higher yielding and lower yielding small cap stocks.

CPI inflation falls to all-time low

Ben Brettell, Senior Economist, Hargreaves Lansdown: 'As expected UK inflation fell in January to 0.3 percent – its lowest level since the Office for National Statistics began to publish the Consumer Prices Index in 1997 (then called the Harmonised Index of Consumer Prices). Predictably, the main contributors were falling fuel and food prices. In the year to January food prices fell by 2.8 percent and fuel prices by 16.2 percent. Together these factors depressed the overall rate of inflation by 0.9 percentage points.' The Bank of England expects the rate of inflation to drop below zero for at least a couple of months this spring, and remain close to zero for the rest of the year. If it turns negative this will be the first ‘deflation’ experienced in the UK since the 1960. Mark Carney was at pains to point out last week that risks of a deflationary slump were minimal, but MPC member Martin Weale (who until December had voted for higher rates) explained that the risk of low inflation expectations causing a deflationary spiral was what persuaded him to abandon his calls for a rate rise.

This suggests opinion at the Bank is somewhat divided. The Bank estimates two thirds of the weakness in inflation can be explained by external factors such as unusually low energy and food prices. The remaining third is down to subdued inflationary pressures domestically. In other words – two thirds ‘good’ deflation and one third ‘bad’ deflation. The combination of low inflation, rising wages and falling fuel prices are great news for the UK consumer. Last week the Bank of England forecast real after-tax incomes would rise 3.5 percent this year, the strongest growth for 10 years. This in turn should be positive for economic growth, and this is reflected in upgraded forecasts from the Bank of England, Confederation of British Industry and the NIESR. These suggest the UK economy will grow between 2.7 and 2.9 percent this year. Turning to interest rates, current forecasts suggest they might start rising later this year or early in 2016. The Bank of England was understandably tight-lipped on the subject in last week’s Inflation Report, only saying it was more likely than not that interest rates will be higher in two years’ time. Throughout the financial crisis and its aftermath the majority of economists and forecasters have predicted rates will go up ‘next year’, and today is no different. I believe they will stay lower for longer then the majority of forecasters expect – I don’t see them rising until mid-2016 at the earliest.

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