Sponsor’s position paper By Nick Clay, portfolio manager, Newton Investment Management
Dividend-paying equities may offer significantly higher levels of income than bonds and cash, but many investors have often not followed a dividend approach. This is perhaps because equities have traditionally been associated with income volatility, as well as a perception that the growth potential of such a strategy may be limited.
However, by focusing on companies with a disciplined approach to capital allocation, we believe a global equity income strategy can provide returns that remain relatively stable and additional capital protection in down markets, as well as the prospect of attractive long-term capital growth.
Fresh look at dividend culture
Company managements, particularly in the US and Japan, are rethinking the role of dividends. After years of strong earnings, coupled with lower capital spending and hiring compared with what has been typical during previous economic expansions, many companies have significant amounts of cash on their balance sheets. Increasingly, they face pressures to either pay or increase dividends or to buy back stock, and many are recognising they will be rewarded more for increasing their dividends than for conducting stock buybacks.
Buying back stock delivers a one-time benefit, but increasing a dividend may improve stock valuations in the longer term, particularly in an environment of slow economic growth where traditional drivers of earnings growth cannot be relied upon to support share prices. With many developed economies deeply mired in debt and, to our mind, likely to grow slowly for the foreseeable future, opportunities in dividend-paying stocks may lie with businesses which possess stable growth and little or no debt – in, for example, the consumer staples, utilities, telecommunications, and health-care sectors.
US opportunities
US dividend-paying stocks may have been considered expensive relative to the overall S&P 500 over the last few years, as investors have increasingly come to view equity-income assets as substitutes for bonds. However, the way investors evaluate dividend-paying stocks relative to other equities, as well as to fixed income, may be changing, making US equity income yields appear to us increasingly attractive compared with global bond yields. At the same time, as some investors reassess the role of dividends in their portfolios, US companies are also shifting the way they think about payouts.
As of 1 April 2016, 60% of S&P 500 companies that paid dividends had yields above that of the 10-year US Treasury note. Twenty-five years ago, only 6% of companies paid dividends higher than 10-year Treasuries, which at the time paid 8.5% compared with less than 2% today, according to US Treasury data. With the current lower interest-rate environment widely expected to persist for some time, we think equity income increasingly looks like a favourable place for an income-oriented investor.
Over the last five years, the overall level of US payout ratios has also risen. That’s partly because the market appears to have rewarded companies that have higher payout ratios with higher equity valuations. Historically, when CEOs of US companies have had to choose between either investing cash to grow their businesses or paying higher dividends, they’ve often opted to invest for growth. Now, with more subdued global growth expectations, US management teams may increasingly see raising dividends as one of a limited number of moves they can make to gain investors’ favour. In the US, raising dividend payments has historically been viewed as an acknowledgment that a company’s end markets have matured, which has tended to depress equity valuations.
However, we observe that US companies are increasingly setting this belief aside and looking more at the potential benefits for their stock prices that can accompany raising dividends. Indeed, for investors, the belief that an inevitable trade-off exists between dividend payments and stock-price growth may indeed be unfounded. Studies of US and other equity markets have found positive correlations between companies’ payout ratios and subsequent earnings growth.
These studies suggest that the payment of a dividend actually encourages greater capital discipline. Contrary to popular belief, we believe many companies are poor at allocating capital, seeking growth rather than returns. If capital is allocated correctly, we think there is a better chance of supporting and sustaining returns on invested capital.
European approach
While the same demographic factors and low bond yields driving demand for equity income in the US are, to our thinking, also present in Europe, we believe European companies continue to approach dividend payments differently than those in the US. Dividend payment is a more common practice for most European companies, which in turn affords income-seeking investors diversification across sectors. We see the greater prevalence of dividend paying in Europe as partly reflecting the fact that the families of many European company founders still hold significant stakes in the companies and rely on the dividends for income. The presence of these shareholders may help increase the likelihood that companies will continue to pay dividends, even under circumstances where management in other regions might choose not to do so.
The prevalence of dividend-focused companies across various sectors makes the European equityincome investible universe somewhat broader than other markets, but that breadth may disguise a lack of depth. We would emphasise that not all of Europe’s dividend paying stocks are equally attractive. Of greater concern for international investors may be the concentrated nature of European stocks. According to a Société Générale study, the 20 highest-dividend paying companies in the UK, France, Germany and Switzerland represent 70% or more of the total dividends paid out in each of those markets. That compares with less than 40% in the US and a global average of 20%.3 In recent years, some of Europe’s most popular income-producing companies, in sectors such as consumer staples and health care, have become more expensive and investors may choose to seek opportunities in more cyclical sectors that have greater potential to benefit from both expanding quantitative easing and more competitive export markets owing to the weakening euro.
Asia and Japan
In recent years, some of the world’s highest dividend yields have come from emerging markets and Asia,4 also home to some of the world’s lowest stock valuations. Of crucial concern for investors, we think, is the question of whether the companies paying those high yields will be able to continue to do so over the longer term. Like dividend-paying stocks in Europe, we see equity income in emerging Asia as being susceptible to the impact of currency exchange rates. Asian economies also face risks from inflationary monetary policy, which lowers the value of the local currency in which dividends are paid, the effect of commodity price swings in countries that depend on commodities, and various geopolitical risks.
One of these risks may be posed by China, whose slowing growth and abrupt policy shifts weigh heavily on regional economies. Besides China, we believe the pace of US Federal Reserve rate increases is a significant concern for Asian companies, particularly those in defensive sectors such as consumer staples, utilities and health care.
In anticipation of those higher rates, we observe that international investors are increasingly shifting exposure to companies with rising dividend payouts and away from stocks they view as more likely to be affected by future US interest-rate hikes. The presumed greater growth potential and lower valuations of companies such as Chinese state-owned enterprises (SOEs), Indian banks and Taiwanese technology firms, to our mind, make them more likely to raise payouts over time, in contrast to traditional dividendpaying companies in mature industries such as telecommunications and utilities.
