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Friday 18 October 2019

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Dividend yield – everything you know is wrong!

Written by David Hogarty
June 2013

David Hogarty explains why investors need to change their attitudes towards income investing

The quest for yield has been one of the biggest talking points in the investment industry in recent years, and the appetite for yield-oriented equity mandates has been on the rise as clients struggle to meet their income objectives, or in some cases choose to stabilise their equity returns. Perplexed investors and commentators bemoan the scarcity of yield in the modern world and the oxymoronic overvaluation of high yielding stocks.

What all this tells us is that investors don’t really understand yield at all and still employ out of date methods to try and capture it. Currently, there is a wide availability of quality stocks with high dividend yields and strong dividend growth pedigrees and they can be bought at below average prices. So what’s the problem? Investors have a tendency to think of income as a separate return stream or as an investment strategy that’s somehow different from other investment styles or approaches. It isn’t. They forget that equities are a total return asset class and that ALL equity returns can be explained by the combination of dividend yield, dividend growth and the change in valuation. Most of all because most investors look at the world on the basis of averages and aggregations, usually market weighted and usually at a country or industry level, they miss a lot of stock specific opportunities. These opportunities also tend to be overlooked because of historic biases, lazy assumptions, and a failure properly research all industries, all regions and all market capitalisations for stocks with strong dividend credentials.

That’s why it’s so important to make sure you continuously revisit every segment of the market. Combining yield-based criteria with other financial health indicators is a great way to find outperforming stocks. Remember only companies with growing profits and healthy cash balances can increase their dividend over time. Dividends can’t be manipulated in the same way as other financial data, so they are a great way of identifying companies that are growing, as well as being reasonably priced. Because dividends are connected to cashflows and profits, a reduction can also be a strong signal that problems are looming.

Because traditionally we have been taught to separate income from capital appreciation it may not be intuitive to use dividend-based analysis to identify outperforming growth stocks or cyclicals but it works very well from an alpha perspective. This also brings the added benefit of a much broader set of investment opportunities, which improves performance potential and the consistency of returns. It also means you can avoid the very narrow risk concentrations and inflated valuations you get at country and industry level
with traditional equity income funds. Diversification helps with consistency of performance from year to year, rather than having your returns dominated by large cap defensives, which can swing in and out of favour as we move through different investment cycles. Some investors think you can’t get diversification if you look for high dividends, but it’s not true. Many of today’s compelling dividend companies are not in traditional or familiar places (e.g they are not large caps, not financials and not mature defensives).

If you want to be a successful equity investor, income hungry or otherwise, it’s crucial to understand that equities are a total return asset class. This means it’s the income and price change combined that generates the return. Most people think the price change is most important in this equation, but again, most people are wrong! To highlight this point let’s look at equity returns with income and compare them to equity returns without income. And let’s do it in a high growth region and keep the time horizon relatively recent. Let’s use emerging markets.

The return of the MSCI Emerging Market Index with income DOUBLED over the past 20 years compared to the return of the same index excluding income. Even in a high growth region where most people don’t even consider the income component, dividends and income are crucially important if you want to maximise your returns. In fact they make up half the total return.

Income gets overlooked because we tend to look at equity returns on a month by month or quarter by quarter basis, when the income contribution can seem small. But because it is always positive and gets reinvested for future growth, over longer time frames, it is hugely powerful. In particular, dividends can completely dominate equity returns when the economic environment is not that positive. Can it be even greater than half the total return? Looking at the contribution that dividends make to equity returns during a similar period of moderate growth historically, the data shows that it is difficult to get any kind of decent investment return without the dividend contribution, let alone outperform.

In the world of investing, “total return” is a widely recognised and accepted approach to measuring equity returns: Dividend yield + dividend growth +/- change in valuation = total return.

The formula can also be used to capture the focus of our investment philosophy at the stock specific level. Central to this philosophy is the extent to which we believe each of these total return drivers is inter-connected. Many interpreters of the above formula tend to consider each element as a standalone ingredient, as if their ongoing dynamics of return contribution were independent and discrete from each other. Our contention is that it is not a linear equation and dividends are an intrinsic measure of the long term sustainability of business profits and a central part of the way those profits are transferred to shareholders. They are not a ‘separate’ or ‘different’ source of return from profitability or valuation, but an intrinsic way of assessing both. Also, managing the payout policy is not a secondary element of management responsibilities but rather management’s primary responsibility to its shareholders. Increasingly over the last decade there has been a very strong relationship between a company’s payout ratio and its long-term valuation.

This can be referred to as a stability premium. Dividends are paid in perpetuity, so when a company increases the share of its profits that it is prepared to share, it is a signal that it is confident it can maintain those payments into the future. This is interpreted by investors as adding a higher level of persistence, or a lower level of risk, to future earnings. This is why we prefer to look at dividends and payouts.

What we are most interested in are companies that are expanding payout. In particular we want companies that can do this because their retained earnings have been building up, and their cashflows are stronger than their competitors. In other words, investors don’t just benefit from the direct impact of the dividend metrics (the yield and growth that is delivered) but also from the overall matrix of financial requirements that are needed within a business to maintain them. Corporate decisions around increasing dividends and payout are rarely a simple, singular, mechanical, financial metric. The constant production of dividend growth requires many elements of profitability to be maintained. It’s this overlapping matrix of elements that we find most attractive.

David Hogarty is head of strategy development, dividend plus strategies, Kleinwort Benson Investors



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