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A seemingly uninspiring stock can in fact reap healthy dividends. Peter Webb looks beyond the charts to achieve investing nirvana

When looking at investments over longer time periods it is important to not only look at the capital growth from an investment, but also the income derived from it. That may sound obvious but the vast majority of popular commentaries on companies generally only include a price chart and rarely expand beyond that. Charts only show the capital value of your investment over time, not return. Total return should always be your objective from the outset.

By total return we mean the price you can sell your investment for plus all income received from it while you held. When we are talking about shares in companies we are basically saying the current price plus dividends and any other payments we have received. Since the income from an investment ultimately drives the valuation of it, it is obvious where your focus should lie.

Beyond the charts

From 1927 to 2001, investor returns in the S&P 500 Index averaged 10.7% per year, 6.1% from capital gains and 4.6% from dividend payments. You can easily conclude that as part of total return, dividends are critically important. This statistic is, in effect, telling you that the price chart of the S&P 500 index over this period is only telling you just over half the story.

Let’s look at an example. Examine a long-term chart of Tomkins (TOMK) and you will be looking at a pretty poorly chart. Since 1999 the stock has risen only a little from around the 212p area to 229p at the time of writing. The rise of just under 8% over this period translates into an annual compounded return of less than 1% per annum. Even with the low levels of interest available on building societies over this period you may have been better investing your money as cash rather than risking it on this company. However, if you look at a share price chart you are often only seeing one side of the coin – capital growth. This is driven more often by expectation and the valuation placed on it more than the facts underlying it. Total return at least allows you a stab at a more level playing field.

In this case Tomkins delivered a total of £1.21 in dividends over the period inclusive of payments in 1999. This has boosted the total return to a much more respectable 61%. The annual rate of return shifts up a gear to over 12% a year. Suddenly your investment is not looking so shabby.

Number crunching

The calculation outlined is a pretty simple version of what could be as simple or complicated as you wish. When you received a dividend in the past you were likely to have done something with that cash. Even if you invested it in a building society at 5% you will see that the present value of a dividend received years ago is more than its initial value. It is these types of factors that don’t appear in a chart.

People have often quizzed Warren Buffett on why he did not sell Coca Cola when it was a multi-year highs, critics consider Buffett’s reluctance to sell anything a weakness. However, if you dig a little below the surface you will find some interesting data. There are eight stocks that dominate Buffett’s core portfolio and most have now been owned for between 10-20 years. In many cases Buffett has already recovered multiples of his initial investment through dividend income and in essence all of the value of the holdings are pure gains. On an amortized cost basis, Coca Cola generates a 13.5% yield, meaning that in seven or so years, Buffett will have more than recovered his investment all over again. Others such as Wells Fargo have more than a 30% yield based on Berkshire’s cost, implying every three to four years Buffett gets full return of his original capital and still has an asset that is worth something. Selling these positions now would generate a significant tax charge. Unless there is a mercurial change in fortunes for these companies or significant overvaluation occurs it would appear to make sense to hold.

Appreciate the dividends

Where the capital appreciation fails to move forward the contribution, dividends can be even more significant. Successfully pick a company throwing off a good dividend and one that has capital appreciation and you will achieve investing nirvana.

In summary, most valuation models tend to take account of the expected total return, but just because the chart looks poor or is not passing a key point in technical analysis terms it definitely should not mean that you ignore or get nervous about buying a share that has the right fundamentals. It could simply be hidden in the total return.