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PortfolioPractice: Academy

Dividend stocks an attractive addition to a portfolio

In the last 40 years dividends contributed roughly one-third to the overall, annualised returns of equity investments.
January 2011

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Decisive Insights for forwardlooking investment strategies

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Content
4 Dividend stocks an attractive addition to a portfolio Dividend yields different from region to region Dividends an underestimated performance driver How sustainable are dividends?

10 Dividend stocks a safe haven? 13 Conclusion

Imprint
Allianz Global Investors Kapitalanlagegesellschaft mbH Mainzer Landstrae 1113 60329 Frankfurt am Main Capital Market Analysis Hans-Jrg Naumer (hjn), Dennis Nacken (dn), Stefan Scheurer (st), Richard Wolf (rw), Lars Dser (ld) Data origin if not otherwise noted: Thomson Financial Datastream.

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Dividend stocks an attractive addition to a portfolio

The equity markets performed well in 2010. Numerous companies registered record profits, so investors have good reason to expect higher dividends this year. Dividend stocks appear to be an attractive addition to a portfolio, particularly in the current low-rate environment. Will the higher dividend payments be sustainable? And what do investments in dividend stocks offer at the moment?
Dividend yields Focusing on high-dividend stocks can considerably boost the dividend yields of a given portfolio

In the current market environment a strategy based mainly on dividends appears attractive. While the average dividend return for European companies (which pay out a large share of their profits in an international comparison) fell from more than 3.5 % in mid-2010 to roughly 3.2 % at the end of 2010 across the market (basis: MSCI Europe) due to the stock-market year-end rally, it is still high in an international comparison. Moreover,

this is only an average figure. With a dividend strategy focusing mainly on a portfolio of high yielding stocks, anticipated dividend earnings can be boosted. According to estimates by data provider Thomson Reuters Institutional Brokers Estimate System (IBES), 25 out of the 463 companies listed in the MSCI Europe will probably pay no dividend at all for 2010. In contrast, more than 120 index companies offered dividend returns of more than 4 % at

Summa Oeconomica
Bond-market yields are comparatively low at the moment. In this capital-market environment dividend stocks appear to be an attractive addition to fixed-income investments. In an international comparison, European and Australian companies are particularly generous and pay out much of their profits to the investors. US companies tend to prefer a more flexible payout vehicle, namely share buybacks. A look at the past shows that dividends are a key factor for a successful equity investment. Dividends contributed roughly one-third to the overall, annualised returns of equity investments in the MSCI Europe between 1970 and the end of 2010. Dividend payouts tend to be steadier than corporate profits. As a result, shareholders receive annual revenues from dividend payments. These revenues are relatively reliable, and investors can do what they want with them. Stocks with high dividend returns have tended to be less volatile. In view of currently low dividend payout ratios in the US, the ratio has even dropped to its lowest level in 40 years and the favourable profit developments in 2010 companies have room for further dividend increases in the future.

Chart 1: Dividend earnings of European equities are at an attractive level

6.5 % 6.0 % 5.5 % 5.0 % 4.5 % 4.0 % 3.5 % 3.0 % 2.5 % 2.0 % 1.5 % 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Dividend yield MSCI Europe

Yield 10-y. German government bonds

Dividend yield MSCI Utilities

Past performance is not an indication of future results; Source: Datastream; Illustration: Allianz Global Investors Capital Market Analysis

the end of 2010. For example, the average dividend yield of European utilities companies amounted to more than 4.5 % at the end of 2010. That means that European companies dividend payments often clearly exceed 10 year German government bond yields (2.9 % at the end of 2010; chart 1). Moreover, price and duration risks of bonds should not be underestimated, particularly not in the current low-rate environment. If companies stick to their dividend policies and stock prices do not move much, equities offer a handsome coupon.

their European counterparts; this instrument is becoming increasingly popular. In 2010, a total of 490 billion (bn) US-Dollar (USD) was spent on buying back shares an increase of 23 % year over year and more than double the amount spent in 2009. In 2006, total dividend payments amounted to only USD 240 bn. Including share buybacks, which may be regarded as an indirect payout to shareholders, the total payout ratio (dividends

Chart 2: Share buybacks are becoming an increasingly important payout vehicle for US companies
8.0 % 7.0 % 6.0 % 5.0 % 4.0 % 3.0 % 2.0 % 1.0 % 0.0 % 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Dividend yields different from region to region

While investors in European equities can currently enjoy high dividend yields, US companies are less generous at first sight. Dividend yields calculated on the basis of 2010 estimates for the Standard & Poors 500 (S&P 500) amount to only about 2.0 % at the moment. Again, focusing investments on high-dividend stocks helps to boost anticipated yields considerably. While 123 companies listed in the S&P 500 did not pay dividends at all, roughly 50 companies paid dividends worth more than 4 % of their market capitalisation. Moreover, US companies are much more interested in share buybacks than

Dividend yield

Yield of share buybacks

Total yield

Source: Standard & Poors; Illustration: Allianz Global Investors Capital Market Analysis 5

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In Japan, direct investor participation in a companys success via earnings distributions is smallest. The dividend yield of the MSCI Japan amounts only to about 1.9 %. Almost all companies show their good faith and pay out at least a small share of overall earnings; only 4 members of the MSCI Japan are unlikely to pay a dividend for 2010. However, only for ten companies does the dividend yield come in at more than 4 %. Here, too, companies enter into share buybacks to a larger extent. At the same time the overall yield level is considerably lower in Japans deflationary environment. In fact, the low dividend yields are still above the average yield of Japanese bonds (see chart 3). A look beyond Japan shows that not all companies in Asia have closed their pockets; some of them are quite generous. Investors who put their money in the Asia-Pacific region can hope for an average dividend yield of 3.2 % (basis: MSCI Pacific ex Japan). Roughly one out of three index members will probably pay a dividend of more than 4 % of the stock price registered at the end of 2010 for the financial year 2010. Australian companies in particular are generous and pay out much of their earnings to shareholders.

+ share buybacks) of US companies rises to an impressive 5.1 % (source: Standard & Poors; see chart 2). A lower number of outstanding shares tends to push up share prices and the earnings per share. However, share buybacks are more volatile and thus less reliable than dividend payments. As a more flexible liquidity-steering tool, they are more closely correlated with the more volatile earnings performance.

Chart 3: Low interest level is one reason for low dividend yields in Japan
7.0 % 6.0 % 5.0 % 4.0 % 3.0 % 2.0 % 1.0 % 0.0 %

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Yield 10y Japanese government bonds

Dividend yield MSCI Japan

Dividend yield MSCI Pacific ex Japan

Past performance is not an indication of future results; Source: Datastream; Illustration: Allianz Global Investors Capital Market Analysis 6

Chart 4: Dividends account for much of the performance

7000 6000 5000 4000 3000 2000 1000 0

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MSCI Europe - Total return index

MSCI Europe - Price index

Performance contribution of dividends

Past performance is not an indication of future results; Source: Datastream; Illustration: Allianz Global Investors Capital Market Analysis

Dividends an underestimated performance driver

A glance at past performance with the proviso of course that this may change in future illustrates the performance contribution of dividends: If an investor had made a single investment of 100 euros in stocks of the MSCI Europe in 1970 and reinvested the dividend payments annually, he would have had 5.126 euros at his disposal (before tax) at the end of 2010 despite the financial crisis. Without the effect of the annually reinvested dividends, i. e. if we consider the pure share price performance, the portfolio would have grown to only 1,169 euros (see chart 4). The bottom line is that a good 40 % of the total annualised earnings of the equity investment over this period amounting to 10 % was accounted for by the dividend payments! In particular, investors in European stocks enjoyed high dividend payments in the past.

European companies pursued a shareholderfriendly payout policy during the past few years. On average, dividends have contributed about 4.1 % to the overall performance of the MSCI Europe since 1970. While the price performance on the North American equity market was comparable during this period (6.4 % p. a., excluding dividends), dividend payments contributed less to the overall performance (3.6 % p. a.). Companies in the Pacific region (in particular in Japan) were least generous, which is why the dividend contribution to overall performance was the lowest world-wide during the past 40 years (only 2.2 % p. a.; see chart 5). There appear to be two key questions for investors seeking information on the future success of dividend strategies: How sustained will dividend earnings be in the current market environment? And what advantages can dividend strategies offer long-term investors?

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Chart 5: Dividend policies most shareholder-friendly in Europe

Performance contribution of dividends and share prices 1970 till 2010 in global comparison (annualised). 12 % 10 % 4.1 % 8% 6% 5.9 % 4% 4.1 % 2% 0% MSCI Europe MSCI North America MSCI Pacific 6.4 % 2.2 % 3.6 %

How sustainable are dividends?

To separate the wheat from the chaff, therefore, investors need to undertake a fundamental sustainability analysis, considering among other things the degree of profitability and dividend continuity of a company. Three factors which hint at stable dividend earnings in the current market environment are: 1. The basis for dividend payments, group profits, probably rose markedly in 2010. In fact, some companies already announced new record gains. According to analysts estimates used by the data provider IBES, European companies (basis: MSCI Europe) will have seen their profits rise by some 35 % in 2009. While the earnings momentum looks set to weaken in 2011, further increases are likely. 2. The favourable earnings development in 2010 is one reason why the dividend payout ratios were recently down markedly. A look at the current dividend policies of

Performance contribution of share prices (p. a.)

Performance contribution of dividends (p. a.)

Past performance is not an indication of future results; Source: Datastream; Illustration: Allianz Global Investors Capital Market Analysis

Chart 6: Low dividend payout ratios offer room for further dividend increases
Dividend payout ratio (dividends/earnings) between 1970 and 2010. 80 % 75 % 70 % 65 % 60 % 55 % 50 % 45 % 40 % 35 % 30 % 25 % 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

Payout ratio of European companies (MSCI Europe)

Payout ratio of US companies (MSCI USA)

Source: Datastream; Illustration: Allianz Global Investors Capital Market Analysis 8

Chart 7: US companies have large amounts of cash at their disposal

US companies have large amounts of cash at their disposal
0.12 % 0.11 % 0.10 % 0.09 % 0.08 % 0.07 % 0.06 % 0.05 %

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Net cashflows of US companies / US GDP (real)

Past performance is not an indication of future results. Source: Datastream; Illustration: Allianz Global Investors Capital Market Analysis

international groups shows that, in Europe, the ratio of dividend payouts and earnings per share is currently moderate in a historical comparison, at about 45 %. In the US, the ratio has even dropped to its lowest level in 40 years (about 30 %; see chart 6). Companies therefore have room for future dividend increases.

3. Companies currently have large amounts of money at their disposal (free cash flow). As the deleveraging process has made considerable progress after the financial crisis and companies have improved their capital base and reduced their leverage, companies might increasingly focus on shareholder value once again (chart 7).

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Chart 8: Dividends are steadier than corporate profits

2000 1800 1600 1400 1200 1000 800 600 400 200 0 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

MSCI Europe: Development of dividends (indexed)

MSCI Europe: Development of corporate profits (indexed)

Source: Datastream, Illustration: Capital Market Analysis Allianz Global Investors

Regular revenues Dividends offer shareholders regular revenues, which are comparatively reliable.

However, there are some factors which argue against a market-wide increase in dividend yields: 1. Historical experience has shown that, after financial-market crises, recoveries tend to be relatively weak and a self-sustaining upswing is slow to emerge. This supports the view that the pace of growth will slow in 2011 after a strong catch-up effect in 2010. Growth looks set to be moderate and below potential. 2. There are still many companies whose profits are volatile, for example banks, which are hard pressed to guarantee dividend continuity in the face of high refinancing needs and increasing regulation. 3. Instead of distributing the free cash flow, companies might search for investment opportunities and resume merger activities. Overall, however, dividends for 2010 will probably be raised; in fact, some companies have already announced increases.

Dividend stocks a safe haven?

Another advantage for investors in highdividend stocks is that dividend payments tend to be steadier than corporate profits. A comparison of dividend payments and profits of the companies listed in the MSCI Europe shows that corporate profits were much more volatile during the past 30 years (see chart 8). One reason is that the dividend policy is often a key part of the corporate strategy. Companies therefore aim at securing steady dividend payments. As a result, shareholders receive annual revenues from dividend payments. These revenues are relatively reliable, and investors can do what they want with them each year. Not only are earnings distributions less volatile, but also have dividend stocks tended to be subject to smaller price movements than the overall market in the past. One possible reason for lower price volatility is that companies with high dividend yields offer investors regular revenues and, in turn, more security. Moreover, companies with a solid dividend history are often assumed to have a solid earnings history,

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too. The Dow Jones Select Dividend index family (which is based on the stocks with the highest dividends taken from broad market indices for a given region) is a good illustration of the risk-return profile of a dividend strategy in comparison to the overall market. The charts 9-11 show that an investment strategy based on high-dividend stocks usually paid off for investors during the last few years, particularly in the euro area. While the broad equity market was up only 1.6 % p. a. since the end of 1998, investors in the Dow Jones Euro Stoxx Select Dividend 30 would have obtained an annualised return of 9.5 % despite the bursting of the dotcom bubble and the recent financial crisis. It is interesting to note that the higher returns of high-dividend stocks compared to the overall market were achieved at the same risks, measured against the market price fluctuations (see chart 9).

Selection criteria for the Dow Jones Select Dividend index family: Companies 1. whose net dividend returns are among the TOP 30 or TOP 100 of the relevant market index, 2. which have not reduced their dividend payments at any time during the past 5 years, and 3. whose dividend ratio is below 60 %. While the U. S. Select Dividend Index covers the 100 US equities with the highest dividends and was first calculated in 1992, the EURO STOXX Select Dividend 30 and the Asia/Pacific Select Dividend 30 indices include the 30 equities with the highest dividend yields in the relevant regions. The history for these two indices goes back to 1999.

High-dividend US stocks have also outperformed since the launch of the Dow Jones U. S. Select Dividend Index in 1992, achieving a return of 12.3 % p. a. vs 11.0 %p. a. for the overall US market. However, the dividend strategy entailed somewhat higher price fluctuations (see chart 10).

High-dividend stocks In the past high-dividend stocks were less volatile than the overall market.

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Chart 9: Dividend strategies with attractive risk-return profiles

Risk-return profile of a European dividend strategy in comparison to the overall market (from 1998 to 2010).

Chart 10: Dividend strategies with attractive risk-return profiles

Risk-return profile of a US dividend strategy in comparison to the overall market (from 1991 to 2010).

25 % 19.7 % 19.8 %

18 % 16 % 14 % 12 % 12.3 % 11.0 % 15.9 % 15.5 %

20 %

15 % 9.5 %

10 % 8% 6%

10 %

5% 1.6 % 0% Performance p. a. DJ Euro STOXX Sel. Dividend 30 Risk p. a. DJ Euro STOXX

4% 2% 0% Performance p. a. DJ U.S. Select Dividend Index Risk p. a. DJ U.S. Price-Index

Past performance is not an indication of future results; Source: Datastream; Illustration: Allianz Global Investors Capital Market Analysis

Past performance is not an indication of future results; Source: Datastream; Illustration: Allianz Global Investors Capital Market Analysis

Only in Asia/Pacific did dividend strategies underperform the overall market. Here, growth stocks did better overall and these equities usually do not belong to the highdividend segment. Still, the lower volatility of the Dow Jones Asia-Pacific Select Dividend 30 in comparison to the broader Dow Jones Asia-Pacific (20.4 % p. a. vs 23 % p. a.) suggests that a dividend strategy in this region is nevertheless attractive from a risk-return perspective (see chart 11). Moreover, dividend payments are not yet included in the analysis. Including aboveaverage dividend payments, dividend stocks outperform the relevant broad market indices even more palpably. While this statement is somewhat unreliable in view of the relatively

short index histories, the result is surprisingly clear even taking into account that data from the past are no guarantee of future developments. The search for dividend earnings carries risks, however, and should not be observed in an entirely uncritical manner. When buying shares, dividend earnings can sometimes give the wrong signals. It is assumed that the current payments will remain stable in future, but that is not always the case. For example, until the middle of 2007 financial stocks were paying glittering dividends. But the onset of the financial crisis brought huge falls in share prices and company profits and dividend payments crashed with them.

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Chart 11: Dividend strategies with attractive risk-return profiles

Risk-return profile of a Asian dividend strategy in comparison to the overall market (from 1998 to 2010).

25 % 20.4 %

23.0 %

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0% Performance p. a. DJ Asia Pacific Sel. Dividend 30 - Price-Index Risk p. a. DJ Asia Pacific Price-Index

Past performance is not an indication of future results; Source: Datastream; Illustration: Allianz Global Investors Capital Market Analysis

Conclusion
The additional revenue stream from earnings distributions is not the only way in which dividend equities can offer added value for the portfolio in the long run. A fundamental dividend strategy, under which equities are selected not on the basis of recently paid, but future, expected dividends, will permit to earn handsome dividend yields despite the price increases of the last few months. This strategy appears to be a promising addition to the equity portfolio, especially in the current low interest environment. Dennis Nacken

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