The amazing power of dividends

A huge slice of market returns are from dividends and dividend growth. Don't miss out on your share of the spoils

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So much of investing goes in cycles. Whether it's the boom and bust cycles of the broader economy or the rhythmic patterns of corporate reporting, investors are used to ebbs and flows.

Having just seen the end of what's euphemistically called 'earnings season' (I'm not sure if allusions to the Bugs Bunny and Daffy Duck 'duck season / rabbit season' skit are intentional or just sometimes appropriate), we now enter the really good bit – the month or two when dividend cheques arrive in our mailboxes or electronically wing their way to our bank accounts.

For the love of cash

It's hard not to love dividends. Not only do we get a couple of payments each year, but dividends from good companies tend to grow most years and in many, many cases are either partly or fully franked – improving the return considerably.

As a bonus, the companies paying those dividends tend to increase profits each year, and earnings not paid out in dividends get reinvested for profit growth which often ends up driving increases in share prices.

Of course, none of the above is guaranteed, and many investors got a nasty shock during the GFC when companies previously considered to be safe, quality companies had to cut dividends to conserve cash. The antidote, by the way, is to buy quality businesses.

A superior option

Is it any wonder cash and bonds pale by comparison? Yes, cash in a term deposit or high interest online savings account is safe, but the interest doesn't carry any of the benefits of franking, and there is exactly zero chance of capital appreciation.

That is, even if you can get 5 per cent, your $5 in interest for every $100 saved is first shaved by tax, and then by inflation – even as your $100 is worth only $97 or $98 by year's end as inflation takes it's cut of your principal.

By comparison, a 4.8% dividend from Woolworths (ASX: WOW) is fully franked, has a long history of growth, and the company is likely to continue to grow its underlying earnings year after year.

Even Telstra (ASX: TLS), after all of its years of trouble, is paying 8.6% fully franked, and while profit growth is still elusive, the current price well and truly allows for that challenge.

Still need to be convinced? Local bourse operator ASX Limited (ASX: ASX) is paying 6% fully franked, even after a double digit compound growth rate in shareholder returns over the past 10 years.

Don't be fooled by low yields

The companies above are the easy pitches. They're likely to be slower growing, and the yields are based on today's dividends compared to today's prices.

Let's just check in on a couple of companies with 'low' dividend yields. Domino's (ASX: DMP) is paying 'only' 2.7% fully franked based on today's price. However, today's annualised dividend of 24.5 cents is a much bigger 8.5% based on the price you could have bought the shares for 3 years ago. Even more impressive is mining services business Campbell Brothers (ASX: CPB), whose current 2.7% yield is a huge 17.4% based on your buy price if you'd picked up the company 3 years ago.

I'm not saying you would necessarily have picked these companies a few years ago, but it highlights the ability of seemingly low-yield companies to deliver large dividends in years to come if they can keep growing.

The cynic in me also appreciates that money paid to shareholders is money that isn't burning a hole in company management's pockets, given that many expansions and acquisitions turn out badly.

The numbers don't lie

I hope I've convinced you, but perhaps I've just picked the best companies to prove a point?

I don't have the numbers at hand for the ASX, but of the US market, Blackrock's co-heads of global equity Richard Turnill and Stuart Reeve in late-2010 said "[s]ome may be surprised to learn that 90 per cent of U.S. equity returns over the last century have been delivered by dividends and dividend growth". Not only is that compelling, but that's in a market whose dividend yields average well below that of the ASX.

Foolish take-away

If you need to speculate on the 'next big thing', that's okay, but know that there's a fair chance it has the characteristics of a lottery ticket, with not too dissimilar odds. There are exceptions – and that's what keeps some people hoping and coming back for more.

Regardless of your personal investing preferences, it's incredibly difficult to ignore the statistical reality, and the opportunity to earn very good returns from what at first blush might be considered to be boring stocks – and why companies such as these should be a core part of most portfolios.

If you are looking for ASX investing ideas, look no further than "The Motley Fool's Top Stock for 2012." In this free report, Investment Analyst Dean Morel names his top pick for 2012…and beyond. Click here now to find out the name of this small but growing telecommunications company. But hurry – the report is free for only a limited period of time.

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Scott Phillips is a Motley Fool investment analyst. Scott owns shares in Woolworths, Telstra and Domino's. You can follow him on Twitter @TMFGilla. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691).

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