This article is part of Morningstar's "Perspectives" series, which is a series of articles written by third-party contributors.
Active fund managers argue that they can beat the market by picking stocks that do better than the average. Risk and liquidity issues are important factors to consider here but, as an exercise to test this thesis, it is interesting to look back and see what stocks now in the FTSE 100 were the best picks 16-years ago on a total returns basis, i.e. with dividends reinvested.
Since September 1994 the best performer was the support services company 
Capita (CPI). Second was the oil exploration company Tullow Oil (TLW), third was the software company Sage Group (SGE), fourth was the mining giant Antofagasta (ANTO), and fifth was the retailer Next (NXT).
Here are the numbers: End value of £100 invested in each stock on September 6, 1994, with dividends reinvested:
| Capita (CPI) | £4,911 |
| Tullow Oil (TLW) | £3,818 |
| Sage Group (SGE) | £3,366 |
| Antofagasta (ANTO) | £3,302 |
| Next (NXT) | £2,356 |
The results shed light on the growth versus income argument. Traditional investors argue that the reinvestment of dividends is the key to long-term performance. This is supported by the Barclays Equity Gilts Study which shows that £100 invested in 1899 would now be worth £160 in real terms, but £22,239 if dividends had been reinvested. The performance of Capita illustrates this. In capital terms £100 grew to £3,620, but reinvesting dividends over those years would have yielded an extra 36%. A similar uplift is evident for Sage and Antofagasta, whilst for Next the uplift from reinvesting its dividends almost doubled total returns over the period to £2,356.
These data also demonstrate the power of compound interest. A seemingly small difference in annualised returns can lead to a vastly different final sum over a long period. Capita’s capital return is only a couple of percentage points lower than the total return (22.1% p.a. and 24.2% p.a. respectively) but by the end of 18 years of reinvesting dividends the outcome is almost £1,300 more.
Returns for Tullow, by contrast, have little to do with dividend flows and are all about growth. Oil explorers reinvest cash-flows boosted by occasional windfalls such as those experienced by Cairn Energy (CNE) in Rajasthan. (Ironically Cairn would have been in the top five, but payment of its last special dividend in March 2012 knocked Cairn out of the FTSE 100 so it could not be considered). The dividend yield for Tullow has remained very low since 2003 when the company first paid a small dividend, though it has risen since.
If dividends are that important shouldn’t investors just concentrate on high yielding stocks, where dividends are high in relation to the share price? The danger here is that a high yield is signalling that dividends are about to be cut, leading to a collapse in the share price and grief all around.
The danger here is that a high yield is signalling that dividends are about to be cut
In time companies with growing dividends, like these five, will overtake such bond-like (i.e. almost fixed income) investments. Longer term outperformance clearly derives from two sources. Firstly a growing dividend should eventually catch up with a high, but stationary dividend. The benefit of a relatively higher dividend for reinvestment will thus fade. Secondly, share prices tend to follow earnings and dividend growth. Capita, for example, has seen its dividend grow from close to zero in 1994 to 22p per share in 2011. Over the last 10 years the dividend has grown at an average of almost 24% p.a. and with no re-rating of the shares over this period (i.e. the dividend yield remains the same) this would lead to a similar average annual share price return. Sage has produced an even more impressive dividend growth rate of 36% compound over the same 10 year period. Thus dividend growth has been the main driver of outperformance here, rather than a re-rating (as evidenced by the dividend yield rising over the last ten years for both).
Dividend reinvestment has been less important for both companies, as reflected in the fact that the average dividend yield for Capita and Sage has been 1.5% and 1.75% respectively over 10 years. By contrast, returns from Next have had more assistance from the reinvestment of dividends. The average dividend yield over 10 years, at 3.3%, is close to double that of Capita and Sage. This is reflected in a wider gap between share price (capital) returns and total returns (14.9% ‘v’ 19.2% compound p.a.). The contribution to total returns from dividends is smaller for Tullow and Antofagasta, and harder to generalise. Tullow only started paying dividends in 2003, whilst Antofagasta has paid small dividends, apart from three large special dividends paid since 2007.
Picking the right stocks can give fantastic returns, but looking at this eclectic bunch it is hard to avoid the conclusion that it comes close to a lottery
Could these returns have been predicted back in 1994? There is certainly very little to connect the five stocks as they come from five completely different sectors. An expert in one sector could have picked the winner in that group. But it is hard to believe a generalist would have selected the best in each. Picking the right stocks can give fantastic returns, but looking at this eclectic bunch it is hard to avoid the conclusion that it comes close to a lottery. How easy was it to predict these businesses would prove classic growth stories with expanding income streams rewarding investors with rising dividends and share prices? Isn’t it easier to just buy the whole market, accept the rough with the smooth and experience less risk and greater liquidity?
The original version of this article was written by Philip Graves, deputy fund manager at Fundamental Tracker Investment Management. The article was originally published in "The Munro December Update" e-newsletter.
Read Graves' previous articles: "Distress Over Dividend Delays" and "Scottish Index Tracker".
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