According to Fidelity International estimates, companies in the U.S., Japan and Europe will pay US$1.24 trillion in dividends to their shareholders in 2016, a distribution policy that is very welcome in the current low or even negative interest environment. But such a policy also leads to a huge demand for dividend stocks, creating an environment that makes some experienced investors a bit nervous, since it often caused problems in the past when too many investors targeted the same asset class at once.
Against this background, the Cayman Islands Journal asked Nick Clay, manager of the Newton Global Income Fund, Daniel Roberts, manager of the Fidelity Global Dividend Fund, and Jan Ehrhardt, manager of the DJE (Dividende & Substanz Fund), how they act under the prevailing conditions.
Interest in dividend stocks is huge and valuation of dividend stocks often rich. Nevertheless, is it currently a good time to invest in dividend funds? (See graph 1)
Ehrhardt: In our view, dividend funds and investing in dividend stocks come closest to the spirit of long-term investing. It involves the identification of good business concepts that will produce regular and rewarding yields. Therefore, we advise to invest continuously in dividend funds.
Clay: With near-zero interest rates unlikely to rise dramatically in the near future, we think that investing in dividend-paying equities – which provide yields that are high compared to other assets – can offer investors the comfort of an attractive income stream in an otherwise low-return environment, and provide a shield against inflation. The current high valuations of many dividend stocks highlight why a passive investment approach based on forecast yield is not appropriate, and why thorough analysis of companies and how they allocate their capital is important. Our strict yield disciplines on the strategy help us to adhere to a valuation discipline on both the buy and sell side.
Roberts: Given the current market environment, dividends are likely to become a bigger component of total returns. While overall market fundamentals and valuations are a cause for concern, there are pockets of value that I am focusing on. I look for companies which have a better chance of sustaining or growing their profits due to enduring competitive advantages such as brands, distribution and regulation, and a willingness to distribute those profits in the form of dividends. These firms appear best placed to navigate the uncertain economic environment.
The combined amount of dividend payments and share buybacks of the S&P 500 Index members currently exceeds the level of the operating earnings. Does that long-term unsustainable situation influence your investment behavior? (see graph 2)
Ehrhardt: We follow that development very closely, but it is important to distinguish when analyzing various sectors. Then it quickly becomes apparent where the vulnerabilities lie. In the case of 8 of 19 sectors, we constantly follow the dividends, plus buybacks exceed the free cash flow. But in the other 11 sectors the free cash flow surpasses these payments to the shareholders. These sectors include technology, pharmaceuticals, telecommunication and commodity companies.
Clay: This highlights the importance of identifying those companies that are well placed to offer a sustainable dividend yield across varied market conditions. Higher yields may be indicative of heig
htened risks. For example, in 2007 the global banks made up some of the highest yielding stocks in the world market; following the 2008 financial crisis, earnings for U.S. and European banks fell to such an extent that many of these companies could no longer sustain their payments. By focusing on companies with durable and robust business models, we aim to provide returns that remain relatively stable, even in down markets, as well as the prospect of attractive long-term capital growth.
Roberts: I would concur with the observation that current levels of distribution are unsustainable longer term as companies in aggregate are raising debt to retire equity to fund buybacks. This does influence my investment decision and I keep a close eye on whether individual stocks are over-distributing. Another important point is that a good chunk of the earnings growth in the U.S. market last year came from the retirement of equity through buybacks. If buybacks at these levels are not sustainable, this will have a knock-on effect for earnings growth potential going forward.
Some sectors with traditionally reliable dividend payers like utilities, energy, finance, telecommunications or healthcare are confronted with problems that endanger their dividends. Did you have to adjust your strategy in the light of this environment? (See graph 3)
Ehrhardt: Of course! We rethink our sector allocation 12 times a year. We are underweight in financials, energy and utilities companies for a long time. Why? For example, the oil companies over many years had invested too much, so that large overcapacities have emerged. That affects negatively not only the stock prices, but also the dividend payments. But at the same time other sectors create new solid dividend payers, like for example recently some technology companies.
Clay: In opposition to the consensus view, we do not think there is an economic recovery on the horizon; we think we are experiencing a global slowdown. Therefore, we have positioned the strategy in those companies which we think are more defensive, more durable and less exposed to the economic cycle. Over time, we have built more dollar-bond proxies into the portfolio, playing the theme of a flattening yield curve, which we have witnessed even after the U.S. rate rise.
Roberts: As a bottom-up stock picker, I have not had to change my investment approach as sectors come in and out of favor. The stocks that I do own in the sectors that you mention all meet my investment criteria and I have no concerns on their ability to continue paying dividends.
Stocks of dividend growers historically seem to deliver the best performance. Does this lead to a preference for dividend growth stocks in your investment strategy? (See graph 4)
Ehrhardt: We also show a performance graph comparable to that one you found on our company website in the section about the investment concept of our dividend fund DJE – Dividende & Substanz. Therefore the clear answer is “Yes.”
Clay: It is important to be very active and select the right stocks: those with sustainable and/or growing dividends, not those with the highest headline payout ratios which may well be dipping into their growth potential in order to maintain dividend levels. The Newton Global Income Fund, for example, outperformed the FTSE World index by 2.7 percent from its inception on Dec. 1 2005 to Dec. 31 2015.
Roberts: Yes, my focus is on the sustainability and growth of dividend payments coupled with downside protection.
Dividend Aristocrats in the U.S. in the past performed better than the overall market. Why have many dividend funds nevertheless had difficulties in beating a benchmark like, for example, the MSCI World Index in the long run? (See graph 5)
Ehrhardt: It is difficult to speak for the competition, but we managed it to beat the world market. This was partly due to our cautious stance in 2008. Especially in very difficult market phases, a fund manager has the chance to generate added value. It is, however, much more difficult to create an outperformance. This partly has to do with a certain cash ratio that funds typically maintain.
Roberts: It is important to highlight the geographic skew that a focus on dividends entails. The skew is away from the U.S. and Japan where headline yields are around 2 percent, and toward regions like Europe and, to a lesser extent, Australia and Asia, where yields are much higher. In the past, the U.S. has comprised as much as 60 percent of the broader MSCI World Index, but only about 40 percent of the High Dividend Yield Index, so a straightforward focus on high dividend yield means a significant underweight to the U.S. Given the extent of the outperformance of U.S. equities, clearly that was been a really significant headwind for dividend strategies and largely explains the underperformance of the High Dividend Yield Index and the broader peer group.
Dividend Aristocrats demonstrated relative strength compared with the overall market during corrections in the past. Does this justify the conclusion that dividend funds are mainly an instrument for defensive investment purposes? (See graph 6)
Ehrhardt: Imagine that you are responsible for a company that increased dividends for 25 years in a row or even longer and you are therefore qualified as a Dividend Aristocrat. This is an incredible track record and it would be a top priority Should you nevertheless decide to cut the dividend, outflows from your stock would be the immediate result. But Dividend Aristocrats usually do not cut their dividends, and investors therefore treat their stocks more like bonds. Thus, it is fair enough to call them defensive.
Clay: Dividends have often been overlooked as a platform for growth. However, thanks to the exceptional power of compounding, the reinvestment of dividends over time can turn equity income into an effective growth strategy for the long-term investor. A recent study illustrated how capital gains accounted for the growth of $1 invested in U.S. equities at the beginning of 1900 to $215 at the end of 2011. However, the additional effect of income and its reinvestment turned that original investment of $1 into £21,978. Accordingly, dividends and their reinvestment accounted for 99 percent of U.S. equity returns over the period.
Further, it is a misconception that dividend-focused funds have to be defensively positioned only. The Newton Global Income strategy in 2005, ‘06 and part ‘07 had a 25 percent overweight to EM and Asia, 35 percent underweight to North America, was overweight in mining, financials, cyclicals. We demonstrated a beta of over 1 to rising markets. Today, we have the opposite. We can and do construct the portfolio to suit the investment backdrop as determined by our investment themes, fundamentals and valuation.
Roberts: Most retail investors would expect a dividend fund to be defensive. However, that does not always pan out if the fund is not focused on the quality and sustainability of the dividend. We saw this in 2008 when a lot of dividend funds were heavily invested in financials and also more recently in resources stocks. It is worth noting that the S&P 500 Dividend Aristocrats index is comprised of quality companies, where quality is defined as the ability of a company to increase dividends every year for the last 25 consecutive years.
It is therefore true that the index does have a natural bias toward the more defensive, less cyclical sectors. However, the Dividend Aristocrat index is not typical of the universe from which dividend funds in general select their stocks, as many dividend funds have an explicit yield target. Funds which have a high headline yield target may be focused less on the quality of the dividend and more on generating an income.