By Mark Whitehead
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 now seem likely to 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.
Demography driving demandLooming over this yield-starved environment are major demographic shifts – slowing birth rates and longer life expectancies leading to a momentous reshaping of the traditional population pyramid in large parts of the globe. From an investment point of view, this 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.
Equity income holding up amid the downdraftHowever, while in the fixed income world, a good yield is becoming the proverbial unicorn, it can still be found in the equity market. 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 therefore able to reward shareholders on a sustainable basis. By taking a global approach it is possible to build a portfolio with a diversified income stream that is not at the mercy of country (or sector) specific risks. And, while the dividend culture in many markets, Asia for example, may historically have been immature, it now offers a growing opportunity set of companies that are willing and able to give shareholders their fair share of profits.
The anatomy of returnsEquities are intimately associated with capital appreciation, overlooking the fact that income is the main driver of long-term returns. Indeed, as the accompanying chart
(see above, inset – click to enlarge) 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 forgetting that, due to the power of compounding, dividends reinvested can materially boost returns over time. Higher-quality dividend payers can provide better risk-adjusted returns than both the broader equity market and bonds. Dividend-paying stocks also 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.
Finding quality?Quality is the long-term investor’s lodestar and this can be established 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, I believe it is important to know that a company will continue to pay out to shareholders even if the times get tough, and therefore stress testing critical financial metrics and conducting extensive credit analysis is necessary to ensure there is adequate future dividend cover.Critically, I also believe it is essential to be comfortable with the softer – ‘qualitative’ – side of a business, which means analysing governance and sustainability factors. Far from being a ‘tick-box’ exercise, this aspect of research is fundamental to building conviction, as material environmental, social and governance (ESG) issues correlate strongly with business performance over the long term. By combining quantitative and qualitative factors it is possible to identify management teams that are likely to be good stewards of capital, and by extension provide durable dividend growth.
SummaryThe 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. This is taken one step further, through a rigorous stress-testing of assumptions and the incorporation of material governance and sustainability factors into a company’s analysis. Finally, taking a global approach avoids being hobbled by geographic constraints, and we are able to seek out the best income opportunities wherever they may be.
Mark Whitehead is head of income at Martin Currie Investment Management
