What investors need is an answer to the 'churn and burn age'

Mike Browne of Seed Investments writes that the company often finds itself quoting and reproducing GMO’s work, and for good measure. GMO is a privately held investment management firm founded in 1977, headquartered in Boston, USA, with offices worldwide.

Several key factors in GMO’s success are: discipline, value orientation, investment research, and constant innovation. These are factors that we at Seed identify with, and it is therefore natural that we find value in much of their work.

As the company’s co-founder and chief strategist, Jeremy Grantham’s views are most often dissected, but James Montier, who forms part of the asset allocation team, is also an astute analyst. We find his views most thought provoking and he writes without fear or favour. His recent white paper on the importance of dividends is a case of point. I’ll take a few interesting pieces out of the report.

Initial dividend yield and the growth in dividends accounts for nearly 80% of total return over five year periods (based on US data since 1871). The remaining 20% or so comes from a change in valuation (i.e. re-rating or de-rating of the PE multiple). Conversely over a one year period nearly 80% of total return is determined by the change in valuation and the remaining amount is explained by starting dividend yield and dividend growth.

From the above chart it would logically flow that most investors would be concerned about dividends when making their investments. Unfortunately (or fortunately for those who follow this approach) many ‘investors’ are myopic in their focus on the next earnings figure for a company. As a result these ‘investors’ attempt to consistently profit from the change in valuation. This is an extremely difficult method to successfully follow as only those who can accurately predict next quarter/half earnings on a repeated basis AND who materially differ from the consensus number will profit from this method. The chart below show how the average holding period has dwindled dramatically over the last 50 odd years on the NYSE as investors take a shorter and shorter perspective.

James Montier goes on to point out that, in the derivatives market, European dividends are currently priced for a depression, which means that they are cheap if the region doesn’t experience a depression over the next ten years or so. Investors taking a longer term view are able to look through the current noise.

A further arrow in the ‘dividend quiver’ is that as companies are generally able to increase their prices in line with inflation, dividends are typically a good inflation hedge over a five year period. As inflation is probably the biggest enemy to a retirement portfolio, this characteristic is particularly attractive. The chart below shows how dividends and inflation move in line with one another.

Ultimately investors who truly have a long time horizon need to make sure that their portfolio contains companies that are priced attractively (good initial dividend yield), and will show good longer term growth (good dividend growth). This can either be achieved through selecting the shares yourself or using a portfolio manager who follows these principles.