Where to look for dividend growth

All investors should love dividends. They are what investing is all about. When we buy stocks in companies that pay dividends, we value them on the present value of all those future payouts.

When we buy shares in companies that don't pay dividends, we do so in the expectation that their businesses will become so successful that they soon will. And every study ever done on the history of stockmarket returns reveals the same thing: thanks to the power of compounding, the majority of our long-term investment returns in real terms come from taking our dividends and reinvesting them.

Those in any doubt need only look at the S&P 500 Total Return Index (which includes dividends) versus the simple index. One example: in the 25 years from 1989 to the end of last year, the former showed a return of 870% and the latter 470%.

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UK stockmarket investors looking at their returns over the past few years will see that this makes sense.Here, dividends have been rising nicely. The payout ratio (the percentage of profits that companies pay as dividends) has risen from 35% to a record level of 65%. And even now, after several years of lousy economic growth in the UK, the dividend yield for the FTSE 100 is still 3.4%.

That doesn't look bad in a world where deposit accounts and bonds yield almost nothing, and it only takes the government offering a savings bond at 4% as an election bribe to create a pensioner stampede.

But in the good news there is also bad. As Sebastian Lyon of Troy Asset Management pointed out to me this week, it is hard for companies to take their payout ratios much above 65% (if they pay out too much, they put themselves at risk of having to cut their dividend if profits fall and unsustainability looks bad). So unless corporate profits can grow fast from here (making the total pot bigger), the long-term outlook for dividend rises from large companies isn't great.

Turn, then, to the almost certainty of low economic growth I have often written about before (it is all about demographics and debt) and to the global earnings situation, and you won't be filled with confidence.

According to Socit Gnrale's Andrew Lapthorne, "global earnings momentum is weak, with 2015 forecasts cut by 10% so far this year in US dollar terms". Much of that is about the oil and financial sectors, but even if you take them out, says Lapthorne, earnings per share estimates are still down 3.5%. It's not particularly encouraging.

So the search for the dividend growth has to move beyond the traditional hunting grounds of the established blue-chips. But where should you look?

There has been something of a surge in the earnings expectations of European companies, as those with overseas earnings look to do well out of the weak euro. So high-quality small and medium-sized companies there are worth considering.

It's also worth investing in Japan for income.This will always sound odd to Japan old-hands given how mean Japanese corporates have traditionally been with their shareholders' cash and there aren't exactly hundreds of Japan income funds on the market (the Jupiter Japan Income Fund being one exception). But the past 30 years of hoarding has left the Japanese corporate sector pretty flush with cash. And a new focus on corporate governance means it looks likeshareholders might soonget their hands on that cash.

Otherwise, you might look to UK small-cap stocks. This will also sound odd: market convention has it that if you want to get good regular dividends, you need to invest in the cash-cows of the investment world the global mega-caps. But Miton's Gervais Williams disagrees.

Some 70% of his Miton Multi Cap Income Fund is invested in small- and micro-cap companies; his Diverse Income Trust, which is biased towards investing in small- and mid-cap funds, offers a yield of about 3.8%; his new investment trust, the Miton UK Microcap Fund, while mainly targeting capital gains in the first part of its life, considers the stocks it buys to be "immature income stocks" he expects them to pay out "sizeable dividends in 3-5 years".

Find a small company with good revenue growth, very little debt, good margins and low valuations, he says, and you can expect good income to follow.

Finally, a word on the bond market. You might have noticed that there has been a degree of carnage over the past few weeks with prices falling and yields rising. This has been nasty for bond investors, and confusing for most other investors. But there will be one group cheering it on: anyone managing a company (or charity for that matter) carrying a large pension-fund deficit.

A good number of UK companies still have pension funds that have guaranteed to pay out final salary pensions to employees. The calculation of how much money they need to have in their funds to meet those long-term liabilities is done using bond yields. The lower yields go, the more cash a fund has to hold(this is boring and complicated, but just the way it is). Over the past few years, bond yields have fallen sharply. So the technical shortfalls in the pension funds have been soaring.

The result is that a large number of companies have become hostage to their pension funds. Some 5,000 are in deficit, and, by the middle of last year, six FTSE 100 firms had pension liabilities greater than their market capitalisation. To satisfy the regulators they have had to pour hundreds of millions of pounds into them.

At the end of last year, the total deficit for FTSE 100 companies was £80bn, and the constituents of the index were forced to pay nearly £7bn to cut it. If bond yields keep rising, that should stop. Anyone looking for long-term beneficiaries of the change in this trend might want to go pension deficit hunting.

As for the companies with the biggest ones in the UK now, you might start with Tesco, J Sainsbury, BT, BAE Systems, Royal Dutch Shell and International Airlines Group, which owns British Airways. If a day comes when they can pay less into their pension funds, you might find that, regardless of global growth, they can pay out more in dividends.

This article was first published in the Financial Times.