Gareth Howlett: ‘Dividend irrelevance’ is an idea that needs a really good kicking

One idea which deserves a particularly good kicking is so-called “dividend irrelevance”. This is the view that, so long as we make certain assumptions about equal taxation of income and capital, it should make no difference to shareholders whether a company hangs on to all its profit or pays some of it out to them in cash as dividends.

The money, in this view, belongs to the shareholders whether it is directly in their hands or in the company’s, and just as it would be irrational to say that ten pounds tied up in the value of your house is worth less than a ten pound note in your pocket, it’s wrong to think you are any better off if the company decides to give you some of your own money.

Anyone who actually believes this should try to pay for their supermarket shopping with a wheelbarrow load of bricks and see how far they get. If superstitious reverence for dividends is an error, it is an error so universal as to be an orthodoxy of its own, as any company which cuts a dividend and sees its share price collapse will know.

You can play games with virtually every item in a set of accounts; but you can’t fake a dividend. Far from an irrelevance, dividends are crucial to the bargain between shareholders and companies. Shareholders provide capital which never has to be repaid, but they get their money back from the profits of the company without having to reduce their ownership by selling shares. In the short term, all the attention goes to the magic number of the index, which measures capital value. Is the FTSE up or down today? In the long term, the very long term, by far the greatest part of your return as a shareholder comes not from selling your shares at a profit but from harvesting the dividends.

So when you next see a sensational news report about so many billions wiped off share values, remember that in the background is a powerful money machine, quietly but steadily pumping out dividends at a rate of over a billion pounds a week. Last year UK companies paid out nearly £68 billion to their shareholders – that’s £68 billion to pay pensions, mortgages, school fees and shopping (and taxes).

The overall payout has fluctuated in recent years for reasons we all know: the recession in general and specific measures such as the abandonment of dividends by the RBS and Lloyds TSB, and BP’s decision to suspend them after the Deepwater Horizon disaster.

But even during this difficult time, the total payout never fell below £55 billion. While the capital value of the market fell by nearly half between the summer of 2007 and the spring of 2009, the peak to trough fall in dividends was only 16 per cent. They rebounded last year and are forecast to grow again in 2012.

Investors need to remember, however, that the principle of diversification applies just as much to dividends as to the allocation of capital. Of the total of £68 billion, a good two thirds is paid by a small group of 15 companies.

If you look at the top holdings of the leading UK equity income unit trusts, a popular sector in recent years with the sharp fall in bond yields and interest rates, the same very small group of names crops up again and again.

One of the more useful innovations from the fund management industry in recent years has been the launch of income funds with a broader, global remit where the manager is free to hunt for generous and solidly financed dividends not just from UK but from the other 90 per cent of the world stock market which is not listed in London. The investment trust sector has been ahead of the game here; as canny shareholders know, several of the most venerable names in the business have been prospecting for dividends on a global scale ever since they started putting money into US railroads and Malaysian rubber plantations. So the theorists have got it wrong: a bird in the hand is definitely worth one in the bush.

• Gareth Howlett is fund manager director at Brooks Macdonald Asset Management