Jeff Salway: Don't forget the dividends, smart investors know their worth

THE famous investor and economist Benjamin Graham once claimed that "Wall Street people learn nothing and forget everything".

Graham also advised conservative investors to invest only in companies that had paid a dividend every year for at least the last 20 years. While that may be a little prescriptive, it's difficult to argue with either assertion.

Investors tend to neglect the impact of dividends and obsess instead over capital growth, but a sharp decline in the dividends paid by UK companies last year reminds us how short-sighted that thinking is.

Just 57 billion was paid out in dividends in 2009, 10bn less than the year before, according to Capita Registrars. It said 202 listed UK firms cut their dividends in 2009, with 74 paying nothing, and the yields paid by the banks alone was down 6bn on the 2008 level. Across the pond, 804 US companies cut dividends and just 1,191 made payment increases last year, according to Standard & Poor's, the highest number of cuts and lowest level of increases on record.

We've become almost immune to this kind of news in the past couple of years, but the impact of lower dividends on investors and pension funds cannot be underestimated. Anyone doubting the value of dividends over the long-term should consider the latest Equity Gilt study by Barclays. It showed someone investing 100 in the UK stock market in 1945 would now have 5,721 to show for it. However, if they had reinvested all of their dividend payments over the period, the 100 would now be worth over 92,000. If that doesn't convince you, a 2002 study of investment returns estimated that just over 90 per cent of real returns from an investment made over 101 years is down to dividends.

This is an pertinent time to consider the value of dividends. Getting a decent income is already a struggle for savers and investors, given the paucity of the returns available on cash and growing fears of a gilts bubble. And although Capita predicted an improvement this year, the lack of dividend options among UK blue chips presents a serious problem for investors and a challenge to the accepted pro-UK bias of most portfolios.

Many investors rely very heavily on a small basket of stocks for the bulk of their dividends. And it's hardly surprising, with fund managers struggling to find decent yields outside a select group of stocks. Almost half of all dividends paid out last year were by just five companies – BP, Shell, HSBC, Vodafone and GlaxoSmithKline. A quarter of all dividends were paid by Shell and BP alone.

The dominance of those five firms goes a long way to explaining why so many funds, particularly in the equity income sector, appear to hold the same positions. Ratings agency Standard & Poor's recently expressed concerns over the extent of this "clustering" in the equity income sector, with most funds holding the same stocks. Vodafone is the top position in almost all of the equity income funds rated by S&P, while BP is a top 10 holding in 88 per cent of funds and Glaxo in 87 per cent.

Such a level of concentration increases the risk faced by investors. Equity income funds form the core of millions of portfolios, but investors holding too many are at risk of a significant overlap, reducing their diversification.

Equity income funds have been hit hard by the downturn, partly because the strongest performing sectors, such as mining, pay little in the way of dividends, and because the traditional yield stocks, most notably banking, have suffered. Barclays has reinstated its dividends and HSBC remains strong, but it could be a while before the banks most affected by the crisis are paying healthy dividends again.

Some equity income funds are now producing strong yields, albeit with the help of derivatives in addition to dividend paying stocks, and the average fund in the sector has grown 24 per cent over the last year. But given that these funds rely heavily on the dividends paid by the UK's blue chip companies, it's no surprise that the yield paid by the typical equity income fund remains low. While the Newton Higher Income is yielding 7.3 per cent and another 13 funds 6 per cent or more, some funds are producing virtually nothing in the way of yields. The good news is that Capita predicted a 5 per cent rise in dividends this year – still low, but still a considerable boost for millions of investors who, even if they don't know it, have a need for yield.