INSIGHTS BLOG

WHY YOU SHOULDN'T UNDERESTIMATE DIVIDENDS

Mark Lister, 15 June 2020

Investing in shares for income, and more importantly income growth, has been a highly successful strategy in many parts of the world, but even more so here in New Zealand.

The NZX All Total Return Index, which reflects the performance of all of the companies listed on our sharemarket, has delivered an annual return of 9.6 per cent over the past 25 years.

That’s an impressive track record, well in excess of the 2.0 per cent inflation rate that has prevailed over the same period. It’s also ahead of national house prices, which have increased 6.3 per cent annually, and NZ Government Bonds, which have returned 6.5 per cent.

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However, the really interesting part is where that 9.6 per cent sharemarket return has come from. If we look at the ‘capital only’ version of the index, the annual return drops to just 3.7 per cent. That means almost two thirds of the return has come from dividends.

It’s a similar story across the Tasman, with about half of the return over the last 25 years coming from dividends, although things change when you go further afield.

In the US, for example, the annual S&P 500 total return has been 9.3 per cent. That’s very close to what the local market has achieved, although almost 80 per cent of the S&P 500 return has come from capital growth, with the contribution from dividends much more modest.

The reason for the much greater focus on dividends in New Zealand and Australia largely comes down to tax. We are two of the only countries (Malta is the only other one, as far as I’m aware) in the world that have an imputation regime for dividend payments.

This means that when a local company pays a dividend to its New Zealand shareholders out of its after tax profits, it is able to pass on a tax credit to those shareholders so they don’t get taxed twice.

They might get a small bill for some additional tax, because the corporate tax rate here in New Zealand is 28 per cent. Many private investors will have personal tax rates of 30 or 33 per cent, so they will have to pay a bit extra to ensure their dividend income has been taxed at their personal rate.

Despite that, it’s still a great system with the vast bulk of dividends passed through to shareholders on a tax paid basis.

In practice, this makes dividends a very efficient way for companies in New Zealand and Australia to return capital to their owners. Elsewhere, this is not the case. That’s why things like share buybacks, rather than dividends, are more common in the US.

The 9.6 per cent return over the last 25 years from domestic shares I mentioned earlier doesn’t include these tax credits. It assumes that cash dividends are reinvested in the index, but it ignores imputation credits (which you can’t reinvest anyway).

However, imputation credits probably add about one per cent to the annual return so you could argue that on a pre-tax basis the local sharemarket has returned slightly more than I’ve quoted.

The fact that most of this return comes from dividends is no bad thing. Income has become an increasingly scarce commodity in recent years, and many investors undoubtedly take great pleasure in receiving their quarterly or biannual dividend payments.

Besides, returns are returns so who really cares how you get them. For those of us with day jobs who don’t necessarily need the cash flow from dividends, we can simply reinvest those payments back into the market if we want to.

At the moment, the average dividend yield (including the imputation credit part) for the NZX 50 is about 3.6 per cent. That falls to 2.4 per cent after tax, if you’re on the top tax rate. Some companies offer yields well above those levels, such as those in the property or utilities sector, and the likes of Spark.

Dividend yields are below historic averages, although they still compare well with the six-month term deposit rate, which is about 1.70 per cent before tax, or a miserable 1.1 per cent after tax.

Shares can be highly volatile, while dividends are only as reliable as the profits they’re paid out of. However, you’ve got a pretty decent shot at growing your income stream (and your capital) over time, as well as keeping pace with inflation.

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