Magazine Issues » September 2019

Dividend investing: Why lower dividend growth isn’t worrying equity income managers

StallionUnderlying dividend growth of 4.6% may be good enough to support the popular equity income sector, and Japan is starting to play a bigger role. Fiona Rintoul reports.

If there’s one thing dividend investing isn’t, it’s life in the fast lane. With their focus on mature, profitable companies, dividend funds tend to invest in stocks that canter rather than sprint.

“Because these businesses are mature, they grow more in line with GDP,” says Jared Hoff, portfolio manager with the Federated International Strategic Value Dividend fund, citing the many mature companies in Europe where he finds investment opportunities for his fund.

But to expect high growth from companies in a dividend fund is perhaps to miss the point. What these funds offer is income, and with investors struggling to squeeze income from traditional sources, such as savings accounts and bond funds, they present a potential solution.

“Traditional sources of income have been diminished and newer sources, with complexities, drawbacks and risks, have emerged,” says John Tobin, portfolio manager and senior research analyst at Epoch Investment Partners.

The extent to which investors have swapped bond funds for equity income funds is hard to gauge. Tobin suggests that “there have been some crossover buyers from the fixed income market as a result of low bond yields” but is quick to note that the benefits of dividend investing are intrinsic; equity income is not simply a replacement for income lost elsewhere.

“Dividends have a long history of being a powerful way to return cash to shareholders and are likely to remain attractive going forward,” he says.

Certainly, figures from the latest Janus Henderson Global Dividend Index report show good recent dividend payouts. In fact, the total paid to shareholders broke a new record of $513.8 billion (€469 billion) in the second quarter of 2019.

However, underlying growth was the slowest in two years at 4.6%. If, as Hoff suggests, the holy grail of dividend investing is “high dividend yield with sustainable dividend growth”, that might indicate problems ahead, but equity income fund managers are unconcerned.

“Last year, the underlying growth rate in global dividends was 8.5%,” says Andy Jones, director of global equity income at Janus Henderson. “We’re coming from a really strong period of dividend growth globally, so 4.6% is a perfectly good outcome. Also, the long-run average from the mid-1970s for dividend growth globally is about 6%.”

And if you’re comparing dividend-paying stocks with bonds, any growth is good. “With bonds, there’s no growth and no inflation protection,” says Hoff.

Increased risk
The flip side is, of course, increased risk. Bonds are not risk-free, but most will agree with Hoff that there is more risk to the income stream with dividend-paying stocks. But in his view, that risk can be minimised, and the way to do that is through rigorous analysis that includes face time with CFOs.

“You need to get inside the heads of the finance guys,” he says.

This also means not taking high dividends at face value. A high dividend yield can be a sign of distress, and so it’s important to understand how it is funded. As Tobin puts it, identifying companies with the highest dividends is easy; determining whether those dividends are sustainable is harder.

“It is important to take a holistic view of the sustainability of a company’s cashflow growth and its commitment to a sound capital allocation policy,” he says. “Focusing exclusively on high dividends can be dangerous and unsustainable.”

This approach is about fundamental company research, but there are some broad sector calls that can be made when looking for dividend-paying stocks. Currently, for example, many banks, which typically cut their dividends during the financial crisis, are paying good dividends again.

“There’s been a pattern around the world that as banks have grown their capital position and become stronger financially, they’ve been able to grow their dividends quite well,” says Jones.

One country where this is particularly evident is the UK. The large banks listed in the UK may have been slow to restart paying dividends, but they are making up for it now. This quarter, Barclays grew its dividend, having cut it in the past, and the Royal Bank of Scotland announced both a special dividend and an ordinary dividend.

“The reason for that was that their capital position has recovered quite well,” says Jones.

Mining is another dividend-paying sector that is well represented in the UK. This year, Rio Tinto paid a high special dividend, returning to shareholders proceeds from businesses it had sold.

“Even underlying performance has been quite good in the mining sector,” says Jones. “The commodity mix allowed them to carry on doing quite a good job on dividends.”

Preference for global approach
However, lack of corporate diversification can be a problem in the UK market. According to Jones, the top 20 stocks in the UK account for two-thirds of market income.

“The UK has a proud history of dividend paying and it was and remains a good market for equity income as the yield is quite attractive, but it is a little bit concentrated,” he says.

Focusing on one market such as the UK can also make it hard to diversify across sectors. “There are certain sectors that it’s difficult to get access to if you stick to a single territory,” says Jones.

Because of this, fund managers often prefer to take a global approach to dividend investing regardless of where they are based. At Federated Investors, even the US-focused strategy can invest up to 30% in non-US companies – an option that the fund managers typically use to the full.

“Dividend opportunities are better outside the US,” says Hoff. “In the S&P 500, yields are 2%. These are the lowest yields in the developed world.”

These low dividend yields in the US are partly a question of culture. US companies tend to be more comfortable taking risks with capital to expand their business than paying it back to shareholders as dividends. And there is a sector angle here too.

“The US has a large, really strong tech sector,” says Hoff. “Those companies tend to pump cash back into the business. They are high growth, low yield.”

Opportunities
At the same time, some non-US investors diversifying away from their home markets do see opportunities in the US tech sector. For instance, Jones cites Microsoft and Cisco as examples of companies that offer decent yields and sustainable growth. “The US also has some semiconductor stocks that offer a good combination of dividend yield and dividend growth,” he says.

On a global basis, there are also some new opportunities coming through to find dividend-paying stocks. One example mentioned by pretty much everyone in the equity income sector is Japan.

Historically, Japanese firms did not pay out much in dividends, even though they were often sitting on a lot of cash. Over the past few years, as Japan has modernised its corporate governance and shareholder relations, that has started to change.
“They have started to pay out a bit more,” says Jones, citing Toyota and the pharmaceutical company Takeda as examples. “Things can change with time.”

In fact, with the rate of dividend growth slowing globally, Japan was one of just four countries to set records in the second quarter of 2019, according to the Janus Henderson Global Dividend Index report, with Canada, France and Indonesia being the others. Overall, emerging markets saw the fastest growth, driven by Russia and Colombia, while Japan was the best performer among developed markets.

The mature Japanese market may be the one that attracts most interest from global equity income fund managers. The nature of emerging markets means the opportunity set there is still limited.

“Many companies tend to invest for growth and thus are not returning substantial cash to shareholders, in terms of dividends and other shareholder distributions,” says Tobin.

Furthermore, there is currently no real need for income investors to take on the additional risk that investing in emerging markets brings.

“Right now, we don’t need emerging markets to generate an income stream,” says Hoff. “We can generate the income stream we need in London and Paris.”

Looking to the future
The question remains: what does the future hold for the equity income sector? If investors have turned to equity income because of the low-yield environment, will they turn away again if interest rates rise?

The first point here is perhaps that this is a big ‘if’. Secondly, equity income has qualities that other income sources don’t. As Tobin notes, dividends have the potential to grow; bond coupons do not. Finally, equity income is not just about income. It is also another way of approaching equity markets.

“The more defensive characteristics help with active return diversification, making dividend investing complementary to passive equity as well as higher beta strategies,” says Tobin.

He also cites studies by Ned Davis Research, which suggest that companies with stable and growing dividends tend to outperform companies that do not pay dividends or have reduced their dividend. Typically, they also do so with less volatility.

“It’s a way of getting into the equity market without full volatility,” says Hoff.

©2019 funds europe