Dividends - long term research undermined?
In a world where interest rates are close to zero, sources of high and sustainable income are increasingly rare, and should attract a premium value. Higher yielding shares can meet this need, and the strategy of buying high yielding shares has a long and proven track record. But investors have to be vigilant as to the risk of dividend cuts, more so now than for many years. The simplest way to adopt this approach is to buy equity income funds that have a track record of achieving a high and growing payout, and they offer instant diversification and specialist management.
Here we review the long term research which makes this approach so compelling, and consider whether the short term outlook for dividends has undermined this research, plus how UK investors must broaden their horizons to reduce the risk of payout cuts.
History suggests we should be very positive about the potential. The well known Barclays Capital long term study of stock market trends informs us that over rolling 10 year periods since 1899 equities have outperformed deposits in excess of 90% of the time. This tendency is even greater if you buy high yielders, clearly illustrated by our most recent research, with the help of London Business School. For example, our research shows that in 85% of 10 year rolling periods since 1900, if you invested in high yielding shares you would have outperformed the stock market as a whole. Arguably this is the only investment strategy that is clearly proven over the long term, and over shorter periods (in this case 10 years) which are more relevant to todays investors.
Some cynics might look at the last 10 years stock market performance and be less than convinced by the longer term research. But look at the half full glass. There were few occasions over the last 100 years when you could have started employing this strategy at a time when the market was 40% below its peak. Or would you rather start employing the strategy only once the stock market has broken up through the previous peak just short of 7000 for the FTSE 100 index?
There have also been few occasions when you could buy high yielders and enjoy such a large margin over returns on deposit and gilt yields.
For example, one of the purist equity income funds, Newton Higher Income, has a yield of 6.5%, and expects to maintain its payout this year. In contrast, deposit rates seem unlikely to improve much any time soon, and even after gilt yields improved in recent weeks, 10 year gilts still yield only 3.8%. And neither a deposit account nor gilts have the opportunity to grow both income and capital.
Armed with these compelling numbers, and a strategy that has a beautiful simplicity, it is a wonder that equity income funds have not attracted more investment over the last few difficult months. After all a yield in excess of 6% is decent compensation while we wait for economies to stabilize and stock markets to recover. Yet it is corporate bond funds that have dominated sales. Within a year or so the present, unusually attractive, potential of corporate bonds will be largely exhausted, and the risk is that investors too overweight in corporate bonds will miss a large part of the early recovery in high yielding equities, and leave themselves exposed in a world where inflation risks will grow, and corporate bonds offer no protection.
The fear was that severe dividend cuts in 2009 would see the case for high yielding equities undermined. To date the outcome has not been so bad. For example, in the 1st quarter 75% of FTSE 350 companies reported either increased or maintained their dividends. Recent research from Capita highlights that total payouts in the first half of 2009 dropped by only 10% compared to the same period last year.
The cut in dividends by two household UK names (M&S and BT) prompted “death of dividends” type headlines. Household names they might be, but in the context of the UK stock market they are not terribly significant, M&S has an index weighting of 0.38% and BT is 0.5%. Moreover, good fund managers were already discounting these cuts.
The dividend swaps market gives an indication of dividend expectations in the years just ahead, and it looked ugly back in June, implying dividend cuts for the constituents of the FTSE 100 index of nigh-on 50% from the peak. But there are problems with these numbers, which many of the gloomsters rely on.
Firstly, there were clear, but very technical, reasons why prices in the swaps market over-stated the risks. Secondly, if the swaps market was right, it implied that by 2011 only six FTSE 100 constituents would still be paying dividends. This is an extreme outcome which we have seen no one suggest.
Interestingly, since 1st September 2008, the month from which it all got ugly, high yielding shares, and the equity income funds which exploit their potential, have been outperforming the stock market as a whole. Although the margin of outperformance has narrowed since March, as low- and non-yielding banks and miners have led the recovery, not all equity income funds are dominated by the defensive mega caps.
For example, JOHCM UK Equity Income is up 45% (1st March-1st September), compared to 32% for the FTSE All Share. Unusually, this fund has 36% in small and mid caps, and although they expect their payout to drop 10% year-on-year, this still leaves the yield around 6%. This fund also illustrates that it is possible to blend a number of manager styles by investing across a range of funds in the sector.
That’s all the good news.
The problem with being too parochial, investing solely in the UK, is that you severely limit your investing universe, as 90% of the highest yielding shares in the world are outside the UK. You also take on more risk by investing largely or solely in the UK. In addition to the possibility of rising gilt yields spiking the stock markets recovery, it is distinctly possible that UK economic growth could be anaemic for a number of years, with two obvious implications:
Interest rates will stay low for a prolonged period, and high yielding shares, where the evidence is that the payout is being maintained, will continue to attract buyers, pushing up values. On the other hand, in a low growth environment there will be fewer companies capable of maintaining their payouts.
As well as a raft of global funds, there are one or two more geographically focused. For example, Newton Asian Income gives access to high growth, low debt, economies, and the manager expects to hold the payout for a yield of 5.4%. Although Europe seems rather lacking in dynamism, the managers of European income funds , such as Olly Russ of Ignis Argonaut European Income, are more excited than any other of their global peers on the potential for payouts and the deep value they are encountering.
In conclusion:
- do embrace the equity income strategy, whether your objective is a high and growing income over time (ideal for SIPPs), or total return.
- don’t be put off by short term pressure on dividends – good managers are dealing effectively with this risk.
- but do not be parochial, and include global funds in your equity income mix.
Dividend Watch is a free monthly e-bulletin tracking these developments, and is available by emailing dividendwatch@DWCifa.com or phoning 020 8467 1666.
(July 2009)