Dividends offer a measure of success

I have tended to concentrate my investment approach on growth shares, trying to identify companies with a low price-earnings ratio in relation to their growth rates. However, in recent years, I have acquired an increasing respect for the dividend yield as an investment criterion.

Stock market confidence in a company is immediately affected by any reduction in dividend. Companies only reduce or pass their dividends when there is little choice - when profits are down drastically or cash is in very short supply.

Even then, many companies still prefer to arrange a rights issue and use a proportion of the proceeds to pay a dividend back to the same shareholders.

This is very inefficient for tax - many shareholders have to find the money out of taxed income to subscribe for the rights issue, only to receive back dividend income which is taxed again.

The 1994 BZW Equity-Gilt Study of the London stock market since 1918 showed that the nominal overall return on equities during the 75-year period was 12 per cent per annum. Adjusted for inflation, the real return was 7.9 per cent compared with an inflation-adjusted 2 per cent for gilts and 1.4 per cent for cash.

The key point is that the dividend yield accounted for 5.1 per cent out of the 7.9 per cent real return. Two-thirds of the real return on shares was therefore accounted for by dividend income.

There are further arguments in favour of high dividend yields as an important investment measure:

In terms of overall return, the average UK Equity Income unit trust has, over the last 20 years, beaten the average UK Growth and UK General unit trust.

Michael O'Higgins, in his book Beating the Dow, has shown that, in America over the last 18-and-a-half years, the 10 highest yielders in the Dow beat the average performers by a handsome margin.

An excellent paper by Capel-Cure Myers drew attention to the work of Levis, who demonstrated that between 1955 and 1988, high-yielding shares beat the UK market as a whole.

I have just read another piece of supportive evidence - a newsletter from US firm, Investment Quality Trends (7440 Girard Avenue, La Jolla, California 92037; dollars 275 for 24 issues per annum). IQT has been very successful in the US market using dividend yields as a prime investment measure. A recent issue analyses the Dow over 53 years and explains how dividends rose in 40 years and fell in 13.

The longest periods of consecutive growth were 1944-1951 and 1983-1990. There were only three occasions when dividends declined for two consecutive years, 1942-3, 1957-8 and 1970-71. The average annual dividend growth over the 53 years has amounted to a very substantial 9.2 per cent. Omitting the very exceptional post-war period 1946-1950, the average growth rate would have been 7.7 per cent.

Dow dividends are currently on the rise and IQT hopes for 6 per cent growth in 1994. Based on this estimate, they rate the Dow as under-valued at 1761 because at that level it would yield 6 per cent.

A Dow average prospective dividend yield of 3 per cent would give a level of 3521 which IQT rate as over-valued. In between, important benchmarks for the Dow are 4 per cent yield (2641) and a 5 per cent yield (2111). If you think the IQT approach has merit, the Dow at 3709 is a worrying portent.

IQT works on a formula basis for individual stocks, applying to them their own distinctive high and low- dividend yields based on historic precedent.

For example, in the April issue, Allegheny Power Systems had a price of dollars 24 and a dividend yield of 6.8 per cent. The potential for the shares to become over-valued allows for a rise to more than double when its distinctive low-dividend yield would be 3.2 per cent.

Conversely, Gillette at dollars 64 has a dividend yield of 1.3 per cent with a potential to fall to dollars 12 when its previously established distinctive high yield would be 7 per cent.

The bias of the IQT recommendations is heavily bearish with far more stocks rated as over-valued than under-valued. In addition, the potential downside of the over-valued stocks was far greater than the potential upside of the under-valued stocks.

At present, in the UK the 15-year gilt yield is just over 8 per cent per annum. By hunting around you can find a few relatively safe loan stocks and preference shares yielding about 10 per cent.

For example, at 943 4 , Standard Chartered 73 8 Preference Shares yield 9.73 per cent gross. A relatively safe yield of almost 10 per cent is very appealing with inflation running at about 2.5 per cent even if it may be about to rise a little.

It is safe and fixed yields like these that make it heavy going for the stock market to make much progress at the moment. As IQT says, declining interest rates led the market up and rising interest rates are likely to lead it down.

If the present down-trend continues, the dividend yields of individual stocks are likely to assume much greater importance.

The author is an active investor who may hold shares he recommends in this column. Shares can go down well as well as up. He has agreed not to deal in a share within six weeks before and after any mention in this column.