Using the proportion of equity returns from dividends to advocate income investing is misleading. It’s the wrong statistic. It’s 73% of a tautology…

Here’s a statistic from Ed Croft:

Over 200 years, equities have returned 7.9% annually, 73% of which has been due to dividends and dividend growth.

Such statistics are often used to encourage investors to buy companies paying a high dividend, erroneously.

I find it surprising only 73% of stock market returns can be explained by dividends. There are very few ways to get money out of a company unless you sell it, in which case someone else has bought it so in terms of aggregate stock market returns no value has been crystalised, no return has been made. The simplest model of company valuation, the dividend discount model, assumes all returns come from dividends.

Investors of all stripes are playing the same game, trying to profit from the dividend earning potential of companies even if they never own a single company that pays a dividend.

The key word is potential. What can we know about a company now, that will help us decide whether it will pay lots of dividends in the future? Some scenarios:

• A research scientist puts money into a nanotechnology startup even though dividends are decades away because he understands the technology and, we hope for his sake, the market and its enormous dividend potential.
• Dividends are paid out of cash flows, money earned by a company after paying the bills and making investments, so strong businesses are likely to be good dividend payers now, or if they’re still investing heavily, in the future.
• Companies that already pay a dividend are likely to continue paying it because investors who own shares because of the dividend income are likely to disapprove of any action to reduce it.

Because you don’t have to wait until a company pays all its dividends to make a return by selling the shares, all of these methods can profit investors but only those investors who correctly identify future dividend payers and buy them on the cheap.

None of these methods guarantee a profit. Companies that pay a high dividend are often mature, or declining, so their potential for paying dividends could well be lower than younger, growing companies. But many young companies will blow up spectacularly before they ever pay a dividend.

Using the proportion of equity returns from dividends to advocate income investing is misleading. It’s the wrong statistic. It’s 73% of a tautology. We know equity returns come from dividends. What we need to know is what’s the best way of, and I hesitate to say it, because I don’t mean it in a precise way, predicting dividend potential.

It comes down to what you feel most confident analysing. In my case, it’s usually the company’s earning power. Nanotechnology is like magic, and dividends are just the product of a good business, now, or in the future.