It is safe to say that savers globally find themselves in quite a predicament. The loose (and unorthodox) monetary policy conditions that followed the global financial crisis have not been unwound and look like they will last even longer. With the central bank liquidity taps open, asset markets are becoming increasingly dysfunctional. Indeed, investors appear to be looking to bonds for capital appreciation rather than income, a curious situation that has helped drive yields from already low levels, to rock bottom.
Government paper in large markets like Germany and Japan has now become a highly unpalatable proposition, with a large section of their respective yield curves in negative territory – guaranteeing investors a loss if they hold until maturity. And there is not much solace in the corporate bond market either, which in some places, such as the US, looks strangely oblivious to default dynamics.
DEMOGRAPHY DRIVING DEMAND
Looming over this yield-starved environment there are major demographic shifts, with the world ‘greying’ with each passing day. Although there are pockets – particularly in emerging markets – where the young are set to outnumber the old for a while yet, large parts of the globe are seeing a momentous reshaping of the traditional population pyramid, thanks in no small measure to the twin-forces of a slowing birth rate and ever longer life expectancies. The economic implications of this are manifold, but from an investment point of view it foreshadows a significant need for income, at a time when it seems so hard to come by. Pension funds looking to match liabilities far out in the future clearly cannot rely on their historical asset allocation formula. So what is the solution?
FOLLOW THE DATA
In many ways it is a case of going back to basics, and the data tells a very clear story. While a good yield is becoming the proverbial unicorn in the fixed income world, it can still be found in the equity market, as illustrated in Chart 1. For all the alarm about a slide into Japanese-style economic stagnation, there are plenty of companies generating strong cash flows – even in these tough conditions – and that are therefore able to reward shareholders on a sustainable basis. And by taking a global approach it is possible to build a portfolio with a diversified incomestream that is not at the mercy of country (or sector) specific risks. It is worth noting that the dividend culture in many markets, for example in Asia, may historically have been immature, but now offers a growing opportunity set of companies that are willing and able to give shareholders their fair share of profits.
Chart 1: Equity income holding up amid the downdraft
THE ANATOMY OF RETURNS
Equities are intimately associated with capital appreciation, but this overlooks the fact that income is the main driver of long-term returns. Indeed, as Chart 2 shows the multiple-expansion component has actually been a detractor of returns over the past 15 years, with the dividend yield and dividend growth doing all the pulling – an observation that applies across markets. Not to forget the fulcrum that is compounding. Dividends reinvested can materially boost returns over time, thanks to some very simple – but often ignored – arithmetic.
The risk in a yield-starved environment such as the current one is that investors start moving along the quality curve in a desperate hunt for income. Rarely is this wise. Higher-quality dividend payers can provide better risk-adjusted returns than both the broader equity market and bonds. A related observation is that dividend-paying stocks tend to be less volatile – typically with a lower maximum drawdown – than their non-paying counterparts, making the journey less nerve-wracking for shareholders worried about the gyrations of markets.
Chart 2: Dividends - the real locomotive
WHAT MAKES OUR APPROACH DIFFERENT?
Quality is our lodestar. At the highest level we establish this by examining a company’s return on invested capital (RoIC), as historical data proves that companies with a consistent and healthy RoIC tend to outperform those with weaker return profiles. In addition, there is a strong statistical link between a superior RoIC and dividend growth. However, by itself, this is not a sufficient criterion. We need to know that a company will continue to pay out to shareholders even if the times get tough, and therefore stress-test critical financial metrics (and conduct extensive credit analysis), to ensure that there is adequate future dividend cover.
GOVERNANCE AND SUSTAINABILITY
Critically, we also need to be comfortable with the softer – ‘qualitative’ – side of a business, and this means analysing governance and sustainability factors. This aspect of our research is far from a ‘tick-box’ exercise but fundamental to our conviction-building, as we believe that material environmental, social and governance (ESG) issues correlate strongly with business performance over the long term. By combining quantitative and qualitative factors we can identify management teams that are likely to be good stewards of our clients’ capital, and by extension provide the durable dividend growth we are looking for.
In summary, the investment logic behind equity income is robust, underpinned by seismic demographic changes. Not only are dividend yields attractive relative to other asset classes, but a quality approach can help achieve a better risk-reward outcome. We take this one step further, through a rigorous stress-testing of assumptions and the incorporation of material governance and sustainability factors in our company analysis. Finally, as global investors, we are not hobbled by geographic constraints, but can seek out the best income opportunities wherever they may be.