A low-yielding environment makes an increasingly powerful case for dividend income in pension portfolios, writes Joseph Mariathasan
The Modigliani Miller theorem may state that company dividend policy should not matter to investors – who should see those profits one way or another – but the fact that there has been a very pronounced increase in appetite for equity income funds, and a significant supply response from asset managers, suggests that things work differently in the real world.
For firms that have managed funds for endowments and foundations this is familiar territory. “Foundations and endowments would typically seek to maintain their capital whilst producing enough income to support the activities that they are engaged in,” explains Charles Congdon, a vice-president at Acadian Asset Management in the UK. But equity income has not been seen as a requirement for other institutions, he adds: “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.”
There is now wide recognition that the future investment environment will be fundamentally different to what has taken place in the past, and the implication for many investors is that dividend income has become a much more important rationale for global equity investment. To paraphrase Lewis Carroll’s Alice, when the going gets tough, jam today always trumps jam tomorrow.
“From 1980 to 2000, asset prices went up and bond yields trended downwards along with inflation,” explains James Harries, manager of the Newton Global Higher Income fund. “We had very long-trending, very benign business cycles. This masked a very pronounced build up of structural debt that was also highly anomalous – but everyone accepted it 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 focused on relative risk, 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 – debt overhangs, ageing demographics, historically low bond yields – has changed dramatically. Investing in equities for dividends when everyone is searching for yield clearly makes sense. “But it’s not only about yield,” says Harries. “It also makes sense because companies that consistently pay out good dividends tend to be well-run, stable companies.”
Perhaps another reason for looking at dividends is that companies are currently flush with cash and have plenty of scope for increasing them.
“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,” says Dominic Neary, head of the global income team at Baillie Gifford.
Equity income funds can certainly look attractive in yield terms compared with bond portfolios: Baillie Gifford’s yields around 4.5% and Newton’s 4.7% and because those income streams would be expected to grow over time, unlike nominal bond yields, they can be thought of as real yields.
The approaches to equity income investing across a global universe cover the full spectrum of active and passive strategies, quantitative and traditional. The common feature for any successful strategy, though, is the ability to differentiate between long-term stable income-generating companies and those that are showing high historical dividend yields because of a fundamentally-driven collapse in share price – the so-called ‘value traps’ – 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,” points out Neary. “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.”
Harries argues that, with the passing of the benign environment in which questionable businesses could be brought to market and thrive, active management has become essential. “With the current de-leveraging backdrop, investors need to be much more cautious,” he warns. “We are wary, for example, of anything to do with China at the moment – steel, coal, cement, Australian dollar, Canadian dollar and so on.”
Nonetheless, active investment in dividend yield can span the globe and come up with surprising results. The discipline of paying dividends consistently is catching on in Asia and other emerging markets, for example (in fact, Acadian Asset Management’s new Global Dividend Yield and Growth strategy, which applies four quantitative models to the top quintile of yielding stocks in the global universe, results in an overweight in emerging markets and underweight in the US).
“Many Asian companies see the benefit of a consistent dividend policy led by widely admired companies such as Samsung and China Mobile,’’ says Neary at Baillie Gifford. “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% per annum.”
Turnover in these strategies tends to be low; Newton’s is around 20-25% per annum. But 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 marketplace for income – namely, telcos, pharmaceuticals, consumer staples and so on – have become more popular and the prospects have been reflected in the share prices, 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.”
While Baillie Gifford’s approach is based on the philosophy of offering an attractive yield, and growing income and capital in real terms in order to generate attractive long-term total returns, more than 20% of its portfolio is invested in stocks with a sub-market yield.
“This gives us exposure to truly real assets and strong capital appreciation potential which can be recycled into income growth over time,” explains Neary. For example, Baillie Gifford bought the non-dividend-paying Baidu in 2010 with a 0.5% weighting. A year later it had doubled in price, providing a capital gain that Neary recycled into Japanese telco NTT, delivering a 4% yield.
The traditional approaches of Newton and Baillie Gifford contrast with the quantitative approaches favoured by Acadian and INTECH in its Global Dividend strategy. While Newton holds around 60 stocks and Baillie Gifford around 90, Acadian and INTECH both have around 200.
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 it, 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.
Fundamental analysis to avoid the value traps might seem to be a prerequisite for income funds – and even Acadian’s quantitative approach is based on bottom-up fundamentals – but INTECH runs 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 a variant of its broader quantitative approach, which takes account of the relative correlations between stocks and their absolute volatilities to produce optimised portfolios designed to outperform any passive index over time.
In the case of high-yield portfolios, INTECH uses the MSCI World High Dividend Yield index, which is composed of those securities in the parent MSCI World 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 1,600 stocks, the High Dividend variant has just over 300. Applying INTECH’s approach to this universe results in a portfolio of 200 stocks with around double the yield of the standard index.
“Our higher dividend portfolio gives the same yield as the MSCI World High Dividend Yield index, but outperforms on a total-return basis,” says David Schofield, president of INTECH International.
So there are passive approaches to dividend income, traditional active approaches, fundamentals-based quantitative approaches, pure portfolio construction-based quantitative approaches and genuinely global approaches. Given that choice, 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?
Clearly, the major issue is the volatility of equity valuations. But it is possible to seek portfolios of stable equities that have significantly lower volatility than the global universe, and significantly higher yield. INTECH’s strategy is clearly designed with this in mind – and it offers a low-volatility version which has exhibited a beta of 0.54 and, between 1996 and 2011, an annualised standard deviation of 10.7% (compared with around 16% for both the MSCI World and its high dividend variant).
George Ross Goobey of the UK’s Imperial Tobacco pension fund famously persuaded the UK pension fund industry to switch to equities as a better match for its liabilities than Gilts in the 1950s. The regulatory pressures and the drive to LDI from the mid-1990s have shifted many schemes back towards bonds. There are risks – the expiry of Bush-era tax breaks that equalised tax treatment of dividends and buybacks is one that could reverse recent trends towards dividend-paying – but in today’s environment of sky-high bond pricing, low-volatility, high-dividend equity strategies may have a more important role to play in matching long-term pension liabilities.