The importance of dividend growth - and how to secure it

Investing in companies with healthy, growing dividends is vital to making decent returns in the long run. But growth may be tough to come by in the next few years. Merryn Somerset Webb explains why, and tips two solid investments to buy now.

In his memoir, Tony Blair claims that it was his idea to give the Bank of England power over interest rates, that he was never "kept out of the economic policy space", and that it was not "until very late on" that he "really yielded control of economic policy".

The "broad framework of economic policy", says Blair, was set "by me".

But if I were him and I was looking to make my place in history a happy one, there is no way I would be trying to make anyone believe this.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

After all, it was giving the Bank of England the interest rate mandate, with instructions to keep inflation at 2% combined with an utter failure of regulation that got us into the banking mess we are currently stuck in.

By effectively claiming to have been responsible for the credit bubble, Blair is as good as asking to be blamed for the hideously distorting effects of its consequence: today's very low interest-rate policy.

He appears to be telling us it is in good part his fault that, after accounting for inflation, we are mostly making a loss on our savings accounts; his fault that house prices bubbled up and are now bumping down; and his fault that annuity rates have now, according to Moneyfacts, hit an all-time low.

This is not something he should expect much of the population to be pleased about. Should he bump into a large group of pensioners, I would expect him to more likely be lynched than cheered.

And that isn't something that is going to change any time soon. The weird shift in the mood of the market at the start of last week, after some not-as-bad-as-expected manufacturing data from the US and China, should not detract from the fact that most economic data is coming in rather worse than expected.

This dismal state of affairs means that, for central bankers at least, deflation is still the biggest risk there is. And that means interest rates will stay low for now. The result? The eyes of anyone looking for yield are once again turning, in some desperation, to the equity markets. After all, while the average savings account now pays you 2% if you are lucky, the FTSE 100 offers an average of 3.5% with a huge number of very good companies yielding rather more.

From time to time, investing for yield falls out of favour and, as GMO's James Montier notes, now is one of those times. Today's markets are dominated not by long-term investors but by speculators so busy with 'burn and churn' buying and selling that they have lost interest in what is surely the fundamental reason for owning shares: the fact that they either produce, or are expected to produce, an income.

This makes little sense given that, as Montier points out, it is dividends that provide most returns. "Looking at the US market since 1871, on average, over the very long term, dividends have accounted for some 90% of total return."

The same goes for Europe, where, since 1970, "80-100% of the total returns achieved" have come from dividends.

Encouragingly for income investors in today's particularly ropey environment, a recent note from Socit Gnrale also points out that, during the long bear market in Japan, investing on the basis of dividend yield has been a good approach.

Even with yields so low, the effect of compounding (getting and reinvesting a dividend every year) has been enough to mean income investors have done slightly better than average. However, this doesn't mean it is a given that a general investing-for-dividends approach is going to automatically work now. Why? Because what is really important for good long-term returns is dividend growth. And we may not see much of that over the next few years.

As we enter a slow growth period for the global economy, companies will start prioritising the hunt for new areas to expand into. That hunt is likely to gobble cash, leaving dividend growth, as Socit Gnrale's Andrew Lapthorne puts it, "dropping down the pecking order".

So, in order to make good returns over the next few years, we need to find not just high-yielding companies but those that "commit to realistic dividend growth" too.

A man you can probably trust when it comes to finding this kind of thing is top-performing income investor Neil Woodford. With all this in mind, you might want to look at his Edinburgh Investment Trust (LSE: EDIN). I object to the fact that its managers charge a performance fee if they do well, but the trust does have a current yield of just over 5%.

Or, if you are after an individual stock, you might turn to one of his top holdings: Tesco (LSE: TSCO). My mother-in-law loathes it on principle, and I can see where she is coming from. But retailing is a highly cash-generative business and, while its shares only yield about the same as the wider market right now, Tesco has a long history of dividend growth. That's good enough for me.

This article was first published in the Financial Times.

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.