Grow your income with dividends from high yield shares: HYP Part I

“Buy! Buy! Buy!” shout the city folk in blue braces from one side of the trading pit. “Sell! Sell! Sell!” retort those with red neckties.

Whatever happened to “Wait! Wait! Wait!” wonders your writer?

These days sharetrading is conducted via computer – the trading is often done automatically according to decisions made by the computers themselves – and the drama of the buyers and the sellers at loggerheads is consigned like steam engines and home brewing to our rosy-tinted memories of yesteryear. Institutions and individuals alike now haggle over shares in front of screens that blink red and blue, with more arrows, buttons and switches than a computer game.

When trading platforms look like fruit machines, it’s no wonder investors behave like short-term gamblers. But there’s a way of profiting from holding shares that requires no selling at all, by receiving the (generally) twice-a-year dividend.

The dividend is the money a company pays every shareholder out of its retained profits, as a reward for holding its shares. It’s too often forgotten that as a shareholder in a company, you’re a part-owner in its business. The dividend you receive is your share of the annual earnings.

Annually, the amount paid out by companies in the London stock market as dividends is about 2-3% of the entire market capitalisation. Some shares pay more: several UK banks, for instance, are currently paying the equivalent of over 6% of their market capitalisation in annual dividends. Others, typically high tech or loss-making companies, don’t pay any dividend.

The amount paid out as a percentage of your shareholding (such as the 6% just cited) is called the yield of the share. There’s more detail elsewhere on Monevator.com regarding calculating the dividend yield; for now it’s enough to know that shares paying relatively high dividends are known as high yield shares.

Do the small percentage returns from dividends sound dull to you? Sure, you won’t hear much about dividends from excited market pundits on CNBC and Bloomberg, who prefer to scream that the price of Wibbly Wobbly PLC has fallen by 0.2% in early morning trading.

What if I was to tell you that over the long-term, the bulk of profits made from investing in the stock market have historically come from receiving and reinvesting dividends?

Incredible, isn’t it? Dividends are the last thing you’ll hear about when reading the financial press or talking to most small investors, yet they’re the lynchpin of all of those reports (such as the CSFB Equity-Gilt Study) that reassure us the UK stock market goes up over the long-term. You’d think there was a conspiracy, if only there was evidence of a huge marketing machine set on encouraging us to churn our share portfolios every time a central banker is late back from lunch, thus racking up lots of lovely dealing fees for stockbrokers. (Uh, hang on a minute… there is!)

Steady economic growth translated into dividends compounded over time can result in huge gains for patient stock market investors. What’s more, putting money in the market with an eye on dividends is perfect for busy investors with better things to do than watch the oscillation of share prices all day. All you need is a strategy, and time.

How dividends made your great uncle rich

Most families have an infamous genetic offshoot whose share investments in the 1950s, ’60s or even ’70s saw them grow old rich. These unfortunately wealthy folk are often too busy fending off the heartfelt enquires of distant drooling cousins and cash-strapped siblings to explain how they actually made their money. (If anyone ever thought to ask, that is – discussing money remains taboo in most British households smart enough to have any financial assets to debate.)

What would Great Uncle Bulgaria tell you if you asked him how he can afford a caviar and Caribbean lifestyle when many of his old age peers have to get by with cheese crackers and caravans? “Come with me,” Uncle Bulgaria might say with a wink. “I’ll not tell you… I’ll show you.”

And with that he’d take you to a dusty attic bedroom cum office, moving aside a chunky wooden chest to reveal a trapdoor in the floorboards, which he’d unlock with a key hidden in his spectacles case. Lifting the lid he’d reveal not an oil well nor a lantern nor even bundles of twenty-year-old £10 notes, but rather… a stash of share certificates.

In the old days of investing – that is, before the Internet – share ownership really did involve taking receipt of share certificates. Some people collect beautiful old examples from the early days of railroads and steamships, and for a few years I hung my Lastminute.com certificate that I acquired at its IPO as a reminder of my own fallibility. (The dotcom company was eventually swallowed up, and I was obliged to return the certificate to get my much diminished cash. In retrospect I wish I’d kept it as a charm to ward off similarly dumb purchases I might consider).

In contrast, with my Internet share dealing account I can buy and sell shares in seconds. Can you imagine the comparative faff that was involved with share certificates? Even if you could stomach the huge fees stockbrokers charged to sell your shares, the hassle of mailing off the certificates to prove your ownership and then waiting for weeks for your loot would be enough to have any Great Uncle reaching for his port. Plenty of shares were likely held for decades out of sheer indolence.

But all those hurdles could have been a blessing in disguise.

While many private shareholders misplaced their share certificates from one year from the next (“Did I put them in a safety deposit box or are they in the sock drawer?”), most would have noticed if their regular dividend cheques stopped coming. Even if a shareholder grew utterly disinterested in the share price performance of his or her portfolio, they still got their regular dividends.

The dividend cheques were almost a ritual – a very obvious second income stream for the wealthy and aspiring classes – and something appealing has arguably been lost now that dividends are more usually paid directly into our electronic share trading accounts.

Despite this loss of poetry, the concrete benefits of dividends remain undiminished. Not only do they pay you a steady income, but most companies aim to grow their dividends faster than inflation. In other words, Great Uncle Bulgaria’s cheques got bigger every year.

How big? Well, consider the leading UK bank HSBC. Its dividend, according to HSBC’s corporate website, has grown at a compound annual rate of 17.3% over the last 15 years. If Great Uncle Bulgaria was receiving £100 a year in dividends from his HSBC shares in 1992, he’d now be entitled to over £1,000 in dividends every year. Ten times as much, from the same shareholding! Reinvesting the dividends by buying more HSBC shares would have produced even greater returns.

To be sure, not every company you buy for its dividends will do as well as HSBC. Some will fare worse, one or two might do even better, and at least a couple will probably skip dividend payments for a time, go bust, or be acquired by a rival for a pittance.

The key therefore is to buy a portfolio of reliable looking dividend payers, so that the winners compensate for the losers. With inflation running at around 2%, it’s wishful thinking to imagine your overall portfolio of high yield shares will grow its dividend much faster than about 5%. However over the long term, those seemingly small but growing returns will add up, especially if you keep reinvesting the dividends into buying more shares for your portfolio.

Bookmark Monevator.com now to follow the rest of the series, where we’ll look at what makes a good dividend paying share, how High Yield Portfolios (HYPs) of blue chip dividend payers have fared in the past, and explain how to construct your own portfolio.