Yield is the obsession of many an income investor, but to us this is secondary to growth. That said, we are not interested in just any kind of growth, and certainly not the suspension-of-disbelief variety often bought into during strong bull markets. Critically, it has to be sustainable, and ultimately translate into a rise in cash flows and dividends. In this viewpoint, we explain the rationale behind this focus: how our investment system is designed to identify businesses with strong financials and competitive moats able to maintain growth, irrespective of shifts in the business cycle.
SUSTAINABILITY THE OPERATIVE WORD
Financial history is rich with examples of growth crazes. During the dot-com boom of the late 90s, investors were falling over themselves to get a piece of what were mere promises of breakneck growth. Similarly, the laws of financial physics were forgotten during the US housing bubble in the noughties – the eventual burst of which precipitated the global financial crisis (GFC). These are prime illustrations of the penchant markets have for a game of greater fool. Of course, growth has a particular connotation for income investors like us – on top of high-level metrics such as turnover, it has to manifest itself in retained earnings and free cash flows, the actual feedstock of dividends.
Importantly, a large dividend is not worth much if it is not sustainable. We are wary of ex-growth companies that may boast a high payout ratio, but where there is a material risk of dividend volatility and poor capital performance. Indeed, our system (including robust research, differentiated income analysis and disciplined portfolio construction) is specifically designed to avoid the dangers of inductive reasoning – of making inferences about future growth merely on what has happened in the past.
This is not to say that historical data does not have any predictive power, but simply that a naïve extrapolation is unwise. We believe that a critical approach where assumptions are thoroughly stress-tested can significantly reduce the odds of investing in a company that could see a sudden deterioration in its ability to reward shareholders.
ASKING THE RIGHT QUESTIONS
Our investment approach is designed to identify companies that we believe have the potential to grow sustainably throughout the investment cycle. In highly competitive markets, few companies have wide-enough moats to expand (let alone maintain) their returns in perpetuity. However, this does not mean that there aren’t firms that are allocating capital wisely and thus can fend off threats to their sales and margins for long periods of time. To isolate these long-term winners we need to build comfort around questions such as:
- What are the drivers of franchise strength and revenue growth?
- Will the competitive environment allow for growth to be repeated?
- What are the operational drivers for revenue growth to translate into cash flow growth?
We look for businesses that are able to seize on structural growth trends, as well as those that may be transforming or undertaking self-help to drive future growth. We rigorously assess a company’s ability to produce robust operating performance to deliver improving earnings and cash flows derived from sales growth, which can then be reinvested to produce future organic growth. Typically, companies that exhibit these attributes are high-quality companies. We have conducted extensive quantitative research to show that high-quality companies, as measured by high returns on invested capital (RoIC) typically outperform the wider equity market, with better risk-adjusted returns, over the long term (10 years). There is also a strong statistical link between high RoIC companies and strong dividend growth.*
To build conviction in an idea we also conduct thorough analysis of a company’s liabilities, assessing its ability to meet its obligations. This helps us reduce the risk of investing in companies that exhibit low growth combined with high financial leverage that may go on to cut their dividends in less favourable market environments. Indeed, we believe placing as much emphasis on what could go wrong, as well as what could go right, is key to building a portfolio that can withstand inevitable periods of turbulence.
PRICE OF EVERYTHING – VALUE OF NOTHING
The prolonged period of accommodative global monetary policy since the GFC has driven an increasingly desperate hunt for yield and attendant drop in discernment among investors. Maintaining valuation discipline is critical in this kind of environment. We want to invest when we believe the market has got its calculations wrong and use a combination of longer- and shorter-term valuation techniques to gauge this.
As alluded to earlier, we tend to steer clear of classic ‘bond-proxies’, where the avenues of profitable capital expenditure (capex) may have been exhausted, but where dividend payments are assumed to run like clockwork. We are willing to accept a lower yield if we believe that a company can continue to raise its dividend into the long term. And, contrary to many other income investors, we would rather see healthy capex than a large return of cash to shareholders via dividends or buybacks.
TAKING THE LONG VIEW
Placing growth above yield may seem like a strange approach for an income investor, but we believe it gives us a stronger understanding of risks and opportunities and therefore helps us identify ideas with real longevity. In many ways, it is a case of foregoing short-term gratification for longer-term gains. Quality and sustainable growth are joined at the hip in our view, and our investment system is configured to find companies which are allocating capital wisely and therefore can provide steady dividend growth throughout the business cycle.
*Source: Martin Currie and FactSet.