BLOG - As good as it gets
Robert Davies, Fund Manager VT Maven Smart Dividend UK Fund
This year has seen double digit gains for equity investors and that naturally raises questions about the prospects for next year. Trying to divine the future is not easy and is of course a key tenet of the Efficient Market Hypothesis. Nevertheless, the knowledge accumulated by the experts who follow the UK’s listed companies, and publish forecasts, should not be ignored.
Francis Galton demonstrated at a county fair in 1906 that the median guess of 800 farmers estimated the weight of an ox to within 0.8% of the true figure. No individual guessed the correct weight of 1198 pounds, but the mean estimate of 1197 is not bad. James Surowiecki in his book The Wisdom of Crowds concluded that if you don’t know something asking enough experts will get you pretty close to the right answer.
Not everyone accepts the argument that equity markets are fundamentally driven by cash flows and dividends, but many people do. It is certainly true there that there is a higher correlation of equity valuations to total returns than just capital returns. In the five years since the market crash of 2008 UK dividend payments have recovered by 33%, from £58 billion to £77 billion. Over the same period the UK equity market has more than doubled on a total return basis.
The collective wisdom of equity analysts following the UK stock market estimates that next year these companies will pay out about £83 billion in dividends, 10% more than this year. Perceived wisdom holds that equity markets discount the next eighteen months in their valuations so it is easy to argue that this increased cash flow is already incorporated in today’s share prices. Some of this upsurge in dividend payments is undoubtedly still a consequence of the recovery from the 2008 recession. So the big question is what happens after 2014 by which time life should be more or less back to normal; whatever that is.
It is not difficult to identify areas of concern. One is the strength of sterling. Since over 45% of UK dividends are declared in dollars the weakness of the UK currency after the crash certainly helped companies with overseas earnings. While it is good news that the UK economy is now one of the fastest growing in the developed world it does mean that many export markets are weak.
There are also specific issues in the UK market, most notably the shrinkage of Vodafone after it sells its US business. As one of the biggest dividend payers in the UK this contraction will have an effect in future years.
It is therefore hard to see why UK dividends, and hence the UK market, will increase as dramatically in the next few years as they have done in the last few years. Even so, a steady dividend income of £80 or £90 billion for UK equity holders provides a yield of nearly 4%. In a world of low inflation and modest growth that is probably as good as it gets for equity investors. In other words, the bulk of UK equity returns will continue to come from dividends rather than capital growth. Reinvesting those cash flows allows them to compound and give better returns than most other asset classes as history has demonstrated over the last century.