History has consistently demonstrated the critical role that dividends – and, in particular, reinvested dividends –play in delivering an attractive total return to investors over time. In this article, we take a look at the constituent parts of an equity investment return and explore the reasons why the equity asset class has been able to deliver such powerful performance through time.
Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
Stock market returns can be boiled down into three constituent parts – dividend yield, dividend growth and the change in valuation which occurs while an investment is held. As the chart below demonstrates, dividend yield and dividend growth have historically delivered the lion’s share of an investors’ return, with change in valuation playing a less influential role. Indeed, in the case of the UK, US, France and Australia, the change in valuation has actually detracted from the total return. Below, we take a look at each of these constituent parts in more detail.
Dividend yield
The dividend is a very powerful force in investment. It represents a tangible return that an investor receives on their investment. As such, the dividend represents a really good way of measuring the relative attraction of an individual stock or equity market.
If you’re investing for income and find a fund that offers a decent starting yield, you’re already off to a good start in terms of return. But, as we explore below, the benefits of a good dividend yield come through much more strongly over the long-term if an investor reinvests them. This is why the dividend yield component in the chart above accounts for the largest slice of the overall return in each region.
BlackRock has a range of five investment trusts that target a balance of income and growth, and the current yield on these trusts is provided in the table below.
| Name | Net yield |
|---|---|
| BlackRock Energy and Resources Income Trust plc | 3.8% |
| BlackRock Income and Growth Trust plc | 4.1% |
| BlackRock Latin American Investment Trust plc | 8.3% |
| BlackRock Sustainable American Income Trust plc | 4.6% |
| BlackRock World Mining Trust plc | 7.4% |
Source: BlackRock as at 31 September 2023.
Dividend growth
Another important contributor to equity market returns historically has been dividend growth. Equities are growth assets – companies tend to grow their revenues, profits and earnings over time, and this could allow them to reward their shareholders with higher dividend payments.
It is important to note that dividend growth is not guaranteed, however. Sometimes companies are forced to cut their dividend or pass on them altogether, because their profits or cash flows cannot sustain that level of shareholder return. Indeed, in challenging economic conditions – such as those seen during the global financial crisis or the Covid pandemic – the aggregate level of dividends across an entire market may decline.
Nevertheless, history suggests that dividends do rise over time, albeit rarely in a straight line. The reason for this is that companies have what is known as “pricing power”, the ability to raise prices over time. This comes in to its own in times of higher inflation and it is one of the main reasons equities have historically done well through inflationary periods such as the 1970s.
Change in valuation
The third element of an equity market’s return is the change in valuation that occurs over a holding period. As the chart above illustrates, it can have a positive or negative influence on overall returns, depending on whether an asset becomes cheaper (which results in a negative contribution to returns) or more expensive (which allows for a positive contribution) over time.
Over shorter time periods, this change in valuation can make a profound difference to an investor’s return. Equities are volatile, and much of the volatility that investors must tolerate is due to swings in sentiment that can have a significant impact on valuation. Broadly speaking, equities will tend to be relatively expensive when there’s not much to worry about in the world, but more attractively valued when there is lots to worry about.
We know from history that markets can move from one extreme of sentiment to another surprisingly quickly, which is why we regularly see equity markets up or down by more than 10% in a single year. This swing in sentiment and the impact it has on market valuations can dominate the overall market return in that year, temporarily surpassing the influence of dividends.
Over longer time periods, however, the influence of these swings in sentiment tends to moderate, allowing the more fundamental contribution from dividend yield and dividend growth to shine through. Hence, the old investment adage, “In the short run, the market is a voting machine but in the long run, it is a weighing machine”.1
The value of compounding
Indeed, the key reason dividends matter more over the long run, is due to what Albert Einstein called the “eighth wonder of the world” – compound interest. Compounding is a good friend of the long-term investor because it does the hard work for you.
The chart below illustrates this effect well. Over 40 years, an original investment of £1,000 which delivers a return of 4% per annum increases in value to around £4,800. On its own the dividend income from an investment can deliver a handsome long-term total return. But if you combine the income with a bit of growth, the impact of compounding is even more profound. If an investment compounds at 8% for 40 years, it turns £1,000 into nearly £22,000.
The figures shown do not contain charges, fees or inflation.
Obviously, this is a very long time period and equity returns will not be delivered as smoothly as illustrated. But if savers start their investment journey early enough, 40 years is not an unreasonable investment horizon to consider, and 8% is not an unreasonable total return to expect from an equity investment. The US S&P 500 Index has delivered an annualised total return of a little over 10% (before inflation) since its inception in 1957.2
So, investors can benefit from the significant value of long-term compounding, and the sooner they embrace it, the better the potential outcomes.
Conclusion
Long-term equity returns come almost exclusively from dividends, in a combination of income and growth. Not much else matters in the long run. This makes the equity market an enticing proposition for investors looking for income or growth or a balance between the two, as long as they are prepared to tolerate the short-term volatility.
On their own, the influences of dividend yield and dividend growth can provide a powerful performance, but active fund managers are essentially aiming to do even better for their investors. By investing in stocks when they are relatively attractively valued – and avoiding stocks that look overvalued – they effectively try to capture the potential positive influence of valuation change as well, boosting overall total returns over time as those valuations normalise. It may not always work, particularly in the short-term, but talented stock pickers have the ability to enhance returns in the long run.
For more information about Blackrock’s diverse range of investment trusts that invest, catering for income and growth investors, please visit our Income & Growth Hub.
