The extraordinary dividend

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Neil Woodford 24 March 2017 Est. reading: 6 min read

The dividend is often called the ordinary dividend, but there is nothing ordinary about it. There is no other piece of information that a company can give to investors, which could more accurately reflect what that business really thinks about its current state of health.

Principally, this is because companies find it very hard to cut their dividends. It is the walk of shame for any board and executive management to cut the dividend – it is a last resort, and rightly so. By contrast, companies that choose to sustain and grow their dividends, are doing so in the knowledge that they are creating a bigger burden for the future – they need to be confident in the sustainability of the business and its future growth prospects, in order to do so.

This does introduce a problem too, however. The difficulty that boards and management teams have with dividend cuts, can lead to some ambiguous behaviour. Sometimes companies will go to great lengths to avoid a dividend cut and this simply stores up trouble for the future. This is where judgement comes into my investment process – I have to make judgements about the sustainability of a company’s dividend which may be at odds with what a management team is saying.

Within the UK stock market, examples of this can currently be found in the oil & gas sector. I believe that both BP and Royal Dutch Shell have unsustainable dividends that are being financed by a combination of debt and asset disposal. In effect, these companies are liquidating themselves rather than facing up to the need for a dividend cut. The only thing that can save them from that eventuality, in my opinion, is a return to sustainably higher oil prices – something that I think is very unlikely to happen. In short therefore, although I know this is a contrarian view because these are widely held shares, particularly by income funds, the oil majors are an unattractive investment proposition while the threat of a dividend cut hangs over them.

Instead, my focus (for the Equity Income Fund and the new Income Focus Fund) is on identifying businesses that are attractively valued and capable of delivering sustainable dividend growth in the years ahead.

There is a simple reason for that focus, which is clearly evident in the chart below. Reinvested dividends have formed a very significant part of the long-term return delivered by equities.

Reinvested dividends provide a powerful boost to long-term equity total returns

With dividends reinvested, £1,000 in 1926 would have grown to £7.8m by 2017

Source: Morgan Stanley, Woodford. Past performance cannot be relied upon as a guide to future performance.

Here we can see the performance of the FTSE All Share index since 1926, in capital terms and in total return terms. Over nine decades, an investor’s capital has appreciated at a compound annual growth rate of 5.4% – this is an attractive growth rate in itself but, with dividends reinvested, the total return from UK equities compounds at an annual growth rate of 10.4%.

This is a product of what Einstein observed to be the 8th wonder of the world – compound interest!

Of course, part of this return can be explained by inflation and, at times, over the last 90 years there’s been a lot of inflation around. But that also highlights one of the other important things that makes equities, and the dividend in particular, special. Equities are real assets – they are stakes in real companies, operating in the real economy, which generate revenues, profits and cash flows that can rise with inflation. With those cash flows, companies pay their dividends which also tend to rise with inflation. Investing in equities therefore comes with an in-built inflation advantage which very few other asset classes can match. Cash and fixed-interest investments are nominal asset classes – they cannot protect an investor from the erosive impact of inflation.

The dividend has always been important to me as an investor and it always will be. The dividend isn’t ordinary – if anything it is extraordinary. And by selecting the most attractive and sustainable dividends, I aim to deliver extraordinary long-term returns to investors.

Find out more about the new CF Woodford Income Focus Fund

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address: 27 Old Gloucester Street, London, WC1N 3AX.

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