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Dividends’ Predictability is Their Big Advantage

December 16, 2011 — The Financial Times — By David Stevenson   Bookmark and Share

I’m going to end 2011 on a seemingly unadventurous note: talking about boring old dividends...but through a vehicle for sophisticated investors that tracks a specialist index.

Why? Because dividends are generally more reliable than earnings for more equity investors. This is why such a large percentage of the funds sold these days are in the “equity income” sector, focused on dividend-paying (and growing) companies with healthy balance sheets.

But I’m interested in a more singular focus on dividends, via indices that track the combined dividend pay-out of companies in the FTSE 100 index or the EuroStoxx50.

My first encounter with this approach was in 2008, when James Montier – then a strategist at French bank Société Générale – suggested that futures contracts tracking aggregate dividend pay-outs were not adequately pricing in dividend growth. His idea was to buy into longer-dated dividend futures, with the express aim of capturing an upswing in dividends as companies resumed their pay-outs.

Montier’s reasoning was twofold.

First, the supply of dividends is a good deal more predictable than the flow of corporate earnings. By and large, companies that pay a dividend are keen to maintain their payments and, if possible, increase them – it signals to the market that the management recognises the value of those regular pay-outs. As a result, there’s a great deal less jiggery-pokery with dividends. You either pay them or not – unlike earnings, where no one seems to know the true “normalised” figure.

Dividend futures: structured product providers

Dividend futures are derivatives that enable investors to speculate on future levels of companies’ pay-outs. But who, you may wonder, would want to sell you a stream of future dividend payments from FTSE 100 companies from now to 2017?

Step forward, the structured product providers. They effectively sell away the dividend returns from an index as part of their investment process. For example, if a structured product offers two times any capital increase in the FTSE 100 index over six years, you can bet that the provider will be looking to sell the dividends from the index as a six-year futures contract.

However, you don’t get many traders of these dividend derivatives in times of economic worry. Hedge fund managers are generally not that interested in a dividend future that might fall by 5 per cent, when they can crucify Italian bonds instead.

Second, dividends have tended to rise in excess of inflation. According to an analysis by BNP Paribas, the average has been 1.5 percentage points above inflation. This fits in with the Barclays Capital (BarCap) Equity-Gilt study, which shows that, since the 1950s, there’s been no rolling ten-year period in which the nominal dividend pay-out has declined.

There is one big caveat to this dividend record: pay-outs may be less volatile than earnings but that doesn’t mean they don’t go down, and markedly in some years. For example, in 2008, dividend pay-outs underwent a 20 per cent decline, followed by a 5 per cent decline the year after.

According to the futures market, more declines are coming. Dividends futures are pricing in a 12 per cent increase in the current year, but then a 3 per cent decline every year through to 2017: a 20 per cent fall from current levels, in nominal terms.

To me, however, that is too harsh.

I don’t think corporate finances will be as stretched as these numbers suggest – most of the big companies still paying dividends will be keen to maintain them, and many have committed to a policy of increasing them. Crucially, I think there is now an expectation that London-listed companies will reward their investors with dividends. If you are a Russian oligarch with no intention of paying a dividend, you’d choose to list on the Chinese or US markets these days. In London, you’d worry that your blue-blooded chairman would try to initiate a dividend pay-out sooner rather than later.

That’s why I believe dividends from FTSE 100 companies will keep pace with inflation at the very least – which implies a minimum pay-out equivalent to 280 FTSE index points in 2017, up from the current level of 202 index points (ie a 4 per cent yield).

This pay-out level is tracked by the FTSE Dividend index. So one way to capture the potential is via Barclays Capital’s FTSE Dividend Tracker: a exchange-traded note (ETN) that pays out the change in the FTSE Dividend index between issuance and December 2016, plus a 2.15 per cent annual coupon.

I believe dividends from FTSE 100 companies will keep pace with inflation at the very least BarCap’s ETN was issued when the index was at 175 and is currently trading at 97p in the £1. Now, as this is an ETN, you are taking a risk on BarCap, as the counterparty, providing the index return. That’s why it is currently aimed at more sophisticated investors through discretionary brokers.

But I’d guess that sooner or later BarCap will bring out a fund version – and competitors will launch more retail-oriented versions. Lyxor ETF already offers a tracker on the DJ Euro Stoxx 50 Dividend Futures index – although I’d be wary of this as I predict heightened volatility in eurozone dividends for a year or two.