Whether you are new to investing or have been active in the markets for years it is important to keep in mind there are two ways an investor can profit from the financial markets.

These encompass a capital gain if, as you hope, the value of your investment goes up. You can also earn an income from many shares and funds paying you dividends or bonds paying you coupons.

Key to unlocking the money-making power of the markets is to understand that these two types of return are not mutually exclusive.

Instead they can complement each other to an eye-catching extent. If you reinvest the income from your investments, then the amount of money you make could go up significantly. This is thanks to the power of compounding – described by Albert Einstein as the eighth wonder of the world.

How does this work? Let’s look at the simple example of a bank account. If you put £1,000 into an account which pays interest of 3% you’ll have £1,030 after one year. Next year, you’ll be earning 3% on the £1,030 rather than just the original £1,000.

In the same way, by putting money into an investment that delivers a consistent income and reinvesting that cash as and when it is received, you capture the returns on your reinvested profits as well as from your original investment.

The effect is even more powerful with dividends because, as you increase your holdings of a particular stock or fund, you also boost the amount of dividend income you receive, with the level of payment dependent on the number of shares or fund units you own. Compounding can be further enhanced if the income stream itself is also growing.

If you had invested £100 in UK equities at the end of 1945 and not reinvested your income the real value of your investment today, factoring in the impact of inflation, would be just £288, and the nominal or absolute value would be £10,933. With income reinvested these totals are transformed to £6,294.26 and £238,690.07 respectively, says the latest Barclays Equity Gilt study.

To put that into perspective the inflation-adjusted figure with income reinvested is a factor of more than 21 times greater than the equivalent figure if the income is not ploughed back into buying more shares or fund units.

This article will look at some strategies for creating a dividend reinvestment portfolio, with investment ideas offering robust income streams which can be reinvested for compounded returns over the long-term.

THE IMPORTANCE OF DIVIDEND GROWTH

For dividend reinvestment to work to its maximum effect you need payments to be consistent and hopefully growing.

For this reason, dividend growth is more important than a high initial yield, particularly if there is a track record of year-on-year improvement in the level of cash paid to shareholders. High yields (such as 6%+) are often signs that dividends are unsustainable (more on this later).

Dividend growth signals the board’s confidence in the company’s long-term cash generation capabilities. You can draw the conclusion that the board sees scope for value accretion in the business over the coming years and therefore you could hopefully see a rising share price plus a steady increase in dividends.

Strong share price performance can mean the yields offered by dividend growth companies aren’t the most eye-catching but over time they could still prove to be excellent investments. The ability to consistently grow a dividend implies a stock is cash generative and shareholder-friendly.

GROWTH CAN BE BETTER THAN YIELD

Inexperienced investors might find it hard to comprehend why income growth can be better than income yield, particularly if a dividend growth stock is offering a current yield circa 2% and a high yield stock offers 10%, for example.

However, high dividend yields are often the result of a falling share price, as we also explain in more detail later on in the section on ETFs. It can be a warning sign that something is wrong with the company or its end markets and therefore dividends may not be sustainable.

Occasionally the market gets it wrong and that can represent a material value opportunity. But the market is generally right, and you may get hit with double whammy of the loss of income from a slashed or even cancelled dividend and a significant fall in the value of the shares if investors are presented with negative news. For dividend ‘reinvestors’ this would undermine your compounded gains.

For example, in April 2018 shares in struggling department store Debenhams (DEB) tumbled as it cut its dividend in half alongside a sorry set of first half results.

As AJ Bell investment director Russ Mould noted at the time, prior to the cut and assuming no change in the full year dividend, Debenhams was trading on a yield of nearly 15%. If a yield looks too good to true, then it usually is.

WHAT MARKS OUT DIVIDEND GROWERS?

Companies delivering dividend growth over the long-term have several attributes in common. Typically, they are cash generative, shareholder-friendly and enjoy consistent track records. These qualities are likely to be underpinned by a strong competitive position and pricing power.

In the words of investment bank Goldman Sachs: ‘Good companies pay dividends. Great companies grow dividends.’

In January 2018 asset manager Royal London changed the name of its UK growth fund to Royal London Dividend Growth (GB00B63DTG61).

Fund managers Niko De Walden and Richard Marwood sum up their approach: ‘The fund is not being positioned for any single macroeconomic scenario, and is instead looking to invest in a range of companies which we believe are in control of their own destinies, irrespective of market conditions.

‘We look for companies with strong business models, robust cash flows and appropriate balance sheets, all traits which should allow long-term dividend growth. Additionally, we are not afraid to buy into these businesses when they are out of favour and their share prices weak.’

Past performance is not necessarily a guide to future performance but the companies in the accompanying table have increased their dividends every year for the last decade or more at an annualised rate of at least 10%. As such they could be a good starting point for someone looking for stocks to research further in order to build a dividend reinvestment portfolio.

Of the names on the list, advertising giant WPP (WPP) is perhaps most at risk of breaking its streak of dividend growth after a spell of disappointing trading and the recent departure of long-running chief executive Martin Sorrell.

Analysts’ consensus estimate is for a very slight increase this year on the 60p paid for 2017 but we wouldn’t be surprised to see dividend estimates change if trading doesn’t improve in the near-term.

Others like Diploma (DPLM) and Intertek (ITRK) have their dividend growth underpinned by supplying products and services that are essential to companies’ day-to-day operations, plus they operate in markets with regulatory drivers.

Reflecting the confidence the market has in these payouts, Diploma yields 2.1% and Intertek 1.5%.

At the very top of the leaderboard is St James’s Place (STJ). It benefits from being in an asset management industry underpinned by a need for more people to prepare for their own retirement.

Backed by a successful strategy of investing its typically wealthy clients’ cash through a network of international fund managers, we reckon the company looks well placed to continue growing the dividend.

Its share price can be prone to volatility if there are wild swings in the stock market but historically many dips have proven to be decent buying opportunities.

USING ETFS AS A WAY OF EARNING AN INCOME

SPDR S&P UK Dividend Aristocrat ETF (UKDV) provides access to the 30 highest yielding UK-quoted companies that have managed to either maintain or grow dividends for at least
10 years in a row.

This screening method means you don’t get exposure to companies that have irregular dividends. The index will remove any companies that cut their dividend.

Morningstar has previously argued this ETF could be better for your portfolio than another popular ETF, iShares UK Dividend (IUKD). The latter may seem more attractive with a higher yield, currently 5% versus UKDV’s 4.2%, yet it exposes investors to the dangers of dividend traps, says Morningstar.

‘(The iShares ETF’s) portfolio is made up of the 50 highest-yielding UK stocks. However, the index that this ETF tracks simply ranks stocks by promised yield. No measures are taken to evaluate the companies’ debt levels or to ensure that they are likely to remain profitable.’

Morningstar says the iShares ETF could provide exposure to a company that is promising a dividend it cannot afford to pay.

Just remember that a lot of companies have high yields as result of a falling share price – that’s the market’s way of saying the dividend is unsustainable. If the market is correct and bad news is on its way, there is a high chance that the dividend could soon be cut, as we’ve recently seen with the likes of TalkTalk (TALK) and Connect (CNCT), both trading on high yields before saying dividends would have to be reduced.

‘Our analysis showed that the companies in SPDR UK Dividend Aristocrats’ portfolio have better profitability characteristics and lower debt. But consistency usually comes at the expense of a lower yield. Nevertheless, in our view, this is a superior investment strategy,’ it concludes.

WHY INVESTMENT TRUSTS MAY BE ANOTHER  SOLUTION TO YOUR INCOME NEEDS

When it comes to paying dividends, investment trusts have a major structural advantage over traditional open-ended funds (e.g. unit trusts and Oeics), as they can retain up to 15% of their annual income for rainy days.

This is added to their revenue reserves, from which they can draw upon to smooth dividend payments from one year to the next to potentially generate a steadily increasing stream of income for their investors.

In contrast, open-ended funds domiciled in the UK have to pay out all of the income that accrues in their annual reporting period over the course of the year.

They do not have the flexibility to set any of it aside, with the result that investors could receive more variable levels of annual income.

Many investment trusts have been able to consistently raise their dividends each year for decades. According to research by the Association of Investment Companies (AIC), 21 trusts have been able to do this for 20 years or more, classified as ‘dividend heroes’.

Some of these trusts will be loath to lose their reputation for income growth, even if their investments aren’t delivering on the dividend front. They will use their revenue reserve to help deliver fairly piecemeal increases in the dividend. 

In order to distinguish those which have delivered meaningful dividend growth, and are therefore good candidates for a dividend reinvestment portfolio, the accompanying table shows the AIC’s dividend heroes ranked according to their level of annualised dividend growth over the last decade.

At the top of the list is Alliance Trust (ATST) with 20.7% annualised dividend growth over the past 10 years. It has a similar multi-manager strategy to Witan Investment Trust (WTAN) which is fourth on the list with 7.8% annualised dividend growth.

You mustn’t presume that higher dividend growth leads to greater total shareholder gains over time. For example, looking at the total return performance (capital gain plus dividends reinvested), Witan has outperformed its peer with 226.6% gain versus 203.9% from Alliance Trust.

Bankers Investment Trust’s (BNKR) 204.7% total return over 10 years is greater than Alliance Trust’s, despite its annualised dividend growth being much lower (6.2%).

It is also important to consider that past performance data overall isn’t an indicator of how well an investment trust (or stock or fund) will perform in the future.

It can help you establish what’s possible from a product, but you also have to consider that market conditions could be very different over the next decade to what we’ve seen over the past 10 years.

Taking the top six investment trusts ranked by dividend growth, the best performer on a total return basis is F&C Global Smaller Companies (FCS) with 319.9% gain, according to data from Thomson Reuters.

We aren’t surprised as smaller companies have historically outperformed large caps. However, you must also consider that smaller companies are higher risk, so you should demand a higher return as compensation for the risk of putting your money into this part of the market. (TS)

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