Global equity income investing

Our case for global equity income investing

Much has been written about the investment case for equity income investing. Many financial analysts have observed that an approach that favours investment in companies with higher than average dividend yields has, in the long run, tended to outperform broader market benchmarks. However, we acknowledge at the outset that it isn’t the holy grail of investing. Like all investment factors and styles its success will ebb and flow. The period from 1998 to 2000, the so-called technology bubble and the post global financial crisis world since 2009 have been good examples of when equity income orientated strategies have underperformed. The market preferring faster growing companies that can reinvest in their own business at attractive rates and falling bond yields have increased the present value of future cash flows as opposed to cash now.

However, dividend strategies are not homogenous; some focus on yield maximisation others focus on dividend growth. Our contribution to this debate is that, as with all good actively managed strategies, the best solution isn’t something that can be replicated by an ETF. The correct dividend policy differs between companies; fund managers need to make judgements at a stock level as to whether companies are allocating capital in the most efficient way. We outline below our beliefs and approach to running an equity income mandate.

Dividends are a key part of investment return

Dividends are a constant, irrespective of their popularity, they continue to make up a consistent proportion of investment returns.

“A stock dividend is something tangible - it’s not an earnings projection; it’s something solid, in hand. A stock dividend is a true return on the investment. Everything else is hope and speculation.”

– Richard Russell (financial commentator).

If we consider the US market, where dividends yields are generally below other regions (Figure 1) as investors and companies generally favour buy backs and reinvestment of cashflow. The importance of dividends is still persuasive (Figure 2). While the popularity and contribution of dividends have varied over time, they have consistently augmented total return, irrespective of price return. It is worth noting that during decades of annualised total returns of less than 10%, dividends play an increasingly important role. In the 1970s, dividends made up 60% of your annualised return, while in the 2000s dividends offset a negative price return. When we think about the overall yield delivered by the portfolio, we view it as a key component of investor return.

Dividend Growth drives share prices

What is clearly apparent from Figure 2 is that the best returns available to investors have come from combining income and capital growth. It’s important for equity income investors that they don’t become too fixated on dividends and thus dismiss companies with a low yield or pay-out, but which have the ability to grow their capital value strongly. Figure 3 highlights this point by showing dividend paying stocks that have not changed their dividend policy have annualised returns that are lower than both all dividend payers and non-dividend paying companies. We firmly believe that it is dividend growth that drives share prices in the long term, not the starting level of the dividend (as demonstrated by Figures 4 and 5).

It’s also why we think of income at a strategy level. We want to combine companies that have a long history of growing dividends with those companies that have a low dividend but are growing rapidly. Strategies that prioritise starting yield or yield maximisation may miss out on some fabulous investment opportunities.

NetEase, the Chinese gaming company (a holding in the strategy) is a great example of this: although the dividend yield is less than 1%, annualised dividend growth over the last 5 years has been c45%. Moreover, share price performance over the last 5 years has annualised c23% return.¹

From a fundamental perspective, companies that have a strong record of dividend growth tend to have strong balance sheets and generate consistent cash flow and earnings. We try to focus on the dividend paying companies of tomorrow, rather than those companies with optically high yields today. Historically, the higher the yield, the less likely it is to be paid.

We are not averse to investing in companies with a higher starting yield than the market. As we have highlighted above, dividends are an important part of total return. However, we firmly believe that irrespective of the starting yield, companies must be in a position to grow their dividends from growing earnings. Quite simply, it is a signal on the overall health of the business. JP Morgan (a holding in the strategy) currently has a dividend yield of 3%, but the business has grown dividends by 16% pa over the last 5 years.¹

Dividend diversity

In trying to deliver the best equity income portfolio, we are not constrained by borders: our opportunity set is truly global. We want to invest in businesses that are diverse by sector, geography and broadly uncorrelated at a strategy level. Figure 7 shows that certain regions are concentrated in the number of companies contributing to overall dividends paid. By taking a global approach we have been able to diversify our dividends and thus minimise the impact of a single business being forced to cut its dividend.

We would describe our approach to equity income investing as pragmatic. We believe that dividends are a valuable source of equity market return which should be sought after. However, we also recognise that growth (earnings, multiple expansion etc.) is an equally important source of return. Having an income mandate should not dissuade us from owning some wonderful companies that can invest in their own business at very attractive rates. We believe we are different by stating that these approaches are not mutually exclusive. The best opportunity for success comes from having a strategy that can invest in both types of business, on a global basis. The common feature we draw from across the strategy is the potential of the companies we own to deliver consistent dividend growth. We believe it is dividend growth that drives share prices in the long term.