Income approaches to equity investing
Investing in companies for their income streams rather than purely capital growth will become more important in the future and the discipline of paying dividends consistently is now catching on even in Asia. “Many Asian companies see the benefit of a consistent dividend policy led by widely admired companies such as Samsung and China Mobile’’ says Dominic Neary, Head of the Global Income team at Baillie Gifford. Yet corporate finance theory and most notably the famous “Modigliani Miller Theorem” states that dividend policy for companies should not matter. The real world though is different from the academic textbooks and the fact that there has been a very pronounced increase in interest by institutional investors in income funds suggests that corporate dividend policy can make a difference to them.
Fixed income yields are so low now that free cashflow yields and dividend yields are the real advantage of equities over bonds for George Greig, Global Strategist at William Blair & Co. “There is a long and growing list of companies whose own stock pays higher dividend yields than their bonds. – Investment grade companies in Switzerland for example like Novartis or Nestle, may have bond yields only a little bit higher than Government bond yields at around say 1% with dividend yields closer to 3%. Investors are overpaying for low volatility of returns! The arbitrage clearly exists for companies to issue bonds to buy back stock.”
The search for higher yields
Not surprisingly, investors are also realising that focussing on income when it comes to equity investing in an environment of low interest rates and uncertain economic backdrop has many merits. “Companies that consistently pay out good dividends tend to be well run stable companies” says James Harries, manager of the Newton Global Higher Income Fund. Moreover, as Neary points out, the corporate sector globally is currently generally flush with cash so there is plenty of scope for increasing dividend yields: “Never in my career have I seen companies with so much cash on their balance sheets, and with relatively limited opportunities to invest for attractive returns with confidence.”
Fund managers are responding to potential demand with a number of firms such as Acadian Asset Management and INTECH introducing new global income funds, while others such as Newton and Baillie Gifford have seen increased institutional interest in existing higher dividend income funds over the last 18 months.
For fund managers who have managed funds for endowments and foundations, this is familiar territory: “Foundations and endowments would typically seek to maintain their capital while producing enough income to support the activities that they are engaged in” explains Charles Congdon, Vice President of Acadian Asset Management (UK). This certainly favoured approaches that focussed on income generation along with capital preservation as prime objectives but as Congdon adds, for other institutions, historically income has not been a requirement. “There has been a period, indeed for most of my career, when markets were storming ahead so fast that income was not a consideration. Any cash that was required could be obtained by top slicing.”
The idea the future environment will be fundamentally different to what has been seen in the past during the careers of current investment professionals is probably well recognised now. Yet the implications are still being assessed. One clear conclusion though that few would dispute is that dividend income has become a much more important rationale for global equity investment. As Harries explains: “From 1980 to 2000, asset prices went up and bond yields trended downwards along with inflation. We had very long trending very benign business cycles. This masked a very pronounced build-up of structural debt and was also highly anomalous but everyone accepted this as the norm. Equities returned around 16-18% per annum, which was not only terrific, but also corrupted the way people thought about investment. People focussed on relative risk rather than absolute, and risk became thought of as not being in the market so ideas like tracking errors against an arbitrary index became critically important.”
The economic and social backdrop has changed dramatically since then, in terms of debt overhangs, demographics with aging populations and bond yields at ridiculously low levels: “So investing in equities for dividends in a period when everyone is searching for yields makes sense.”
Equity income funds can certainly look attractive in yield terms compared to bond portfolios with INTECH’s strategy yielding around 4%, Baillie Gifford’s around 4.5% and Newton’s strategy yielding 4.7%, with the income streams growing over time, so, unlike nominal bond yields, they can be thought of as real yields.
Active and passive
The approaches to equity income investing across a global universe covers the full spectrum of active and passive strategies, quant and traditional. The common feature for any successful strategy though, is the ability to differentiate between long term stable income generating companies, and those which are showing high historical dividend yields because of a collapse in share prices or a one–off event: “High yield today doesn’t mean high yield tomorrow and analysts are weak when it comes to forecasting dividends on a timely basis” as Neary points out.
Harries argues that active management is essential. “In a benign environment, a lot of questionable businesses were brought to the market and thrived. But with the current deleveraging backdrop, investors need to be much more cautious and we are wary for example, of anything to do with China at the moment – steel, coal cement, Australian dollar, Canadian dollar and so on as China is seeing a slowdown which after its long period of growth, will come as a shock to investors” says Harries.
Active investment can span the globe and come up with surprising results, says Neary. “We bought a small company in Brazil called Brasil Insurance, which has been the leading consolidator of the insurance brokerage industry there. As it does not take underwriting risk, and simply takes commission on policies written, its cash flow characteristics are fantastic. Because of this, although a young company, it offers a 5% yield with earnings and cash flow growing at 15% p.a.”
Yet even though turnover may be low with Newton’s around 20-25% per annum, active managers such as Harries would argue that managers have to be prepared to adjust their portfolio in the light of changing valuations: “The quality parts of the market place for income, namely telcos, pharmaceuticals, consumer staples and so on have become more popular and the prospects in sectors such as consumer staples have been reflected in the share prices and so the relative value of our portfolio has deteriorated somewhat. We are closer to the time when we should be selling some of those stocks than we were 18 months ago, but we do see the inherent attractions of these sectors will drive their values to higher levels.”
The traditional approaches of Newton and Baillie Gifford contrast with the quantitative approaches favoured by Acadian in their new fund and INTECH. While Newton have around 60 stocks and Baillie Gifford around 90, Acadian and INTECH both have around 200 in their high dividend strategies. Acadian’s approach is based on applying four quantitative models to the top quintile of stocks in the global universe in terms of yields. This gives them, in contrast to Newton, an overweight position in emerging markets and underweight in the US.
Traditional approaches to stock selection and even the active quant approaches of firms such as Acadian’s are predicated on a fundamental analysis of company prospects. For such managers, fundamental analysis is critical to avoid pitfalls such as value traps where high current dividends may not be sustainable. It also enables them to avoid companies and sectors that may be subject to fundamental changes caused by changes in government taxation for example: “The Australian resources tax has completely changed the competitive position of Australia as a resource provider for Asia. It has the potential to decrease the growth of dividends over the long term in companies such as BHP and Rio Tinto, with large exposures to Australia” explains Neary. As he also points out, a bigger worry is the expiry of the Bush era tax breaks which resulted in an equalisation of tax treatment of dividends and buybacks which resulted in companies becoming more favourably inclined towards dividends. The worst outcome would be the opening up of a large gap between taxation of income and capital which may result a reversal of this trend.
Fundamental analysis may seem to be a prerequisite for income funds, but INTECH run a successful high income global portfolio that is designed to beat passive indices with no fundamental analysis at all. INTECH’s approach to high income investing is just a variant of the INTECH quantitative approach, which is based on one simple but powerful observation. That is that any capitalisation weighted index is not an efficient portfolio in the Markowitz sense of maximising return for a given level of risk. INTECH’s premise is that it is possible to consistently beat any index by producing efficient portfolios that take account of relative correlations between stocks and their absolute volatilities and then producing optimised portfolios taking account of trading costs. In the case of high yield portfolios, as David Schofield, President of INTECH International explains, INTECH use the MSCI World High Dividend Yield Index as their starting point.
As MSCI state, the index is composed of those securities in the parent index that have higher-than-average dividend yield, a track record of consistent dividend payments and the capacity to sustain future dividend payments. While the standard index including emerging markets has 1600 stocks, the High Dividend variant has just 322 (at end December 2011). Applying INTECH’s approach to this universe results in a portfolio of 200 stocks with around double the yield of the standard index. Schofield explains: “Our higher dividend portfolio gives the same yield as the MSCI World High Dividend Yield Index, but outperforms on a total return basis.”
In a world where government bonds are no longer seen as risk free, can dividend paying equities have a more prominent role in the portfolios of pension funds with well defined liability streams?
If managers focussed on the stability and sustainability of dividend streams that may require a radical reappraisal of their attitudes to the definition of risk. This lies at the heart of the debate regarding the use and abuse of equity indices. Modern portfolio theory has been built around the idea that investors make a choice between returns and the risk of those returns as expressed by their volatility, the “standard deviation” of the returns. The idea of efficient markets has led, erroneously as INTECH would point out, to the idea of the market portfolio represented by the major capitalisation weighted indices as the most efficient portfolio. But while the use of global equity indices as comparisons for performance benchmarks makes eminent sense, their implicit or explicit use as tools for the management of equity risk needs to be handled with more care. If a portfolio of stocks has a more stable dividend stream than the global index and it has a lower absolute volatility, then an intuitive view of risk would state that it is less risky for a long term investor. But the tracking error of such a portfolio against a global capitalisation weighted index could be high.
Clearly, the major issue is the volatility of equity valuations and against what benchmark risk should be measured. But it is possible to seek portfolios of stable equities that have significantly lower absolute volatility than the global universe, and significantly higher yield. INTECH for example, have a low volatility version of their high dividend strategy which, as Schofield explains, has a beta of 0.54 and in the period 1996-2011, had an annual standard deviation of 10.7% compared to the around 16% of both the MSCI World and the high dividend variant. With current government bond yields ridiculously low and their risk free status as a concept no longer valid, low volatility high dividend equity strategies may have a more important role to play in matching long term pension liabilities.