A strategy we believe will always deliver long-term is buying good value, quality assets and letting them accumulate by reinvesting their dividends. A basket of dividend-paying, quality companies should be a staple in any portfolio. It’s so often repeated, perhaps because as investment mantras go, this one actually works: dividends matter. But why, and why now?
First the why
In simple terms, dividends are an excellent stock selection guide; dividend payers have outperformed the broad market, and non-dividend payers significantly underperformed.
Second, if you invest with patience, dividends’ significance increases dramatically. They deliver 60% of total returns over an average 20 year period (Note 1). And they’re even more important in periods of low returns (over 75% of returns in the 1940s and 1970s).
Dividends are much more stable than company earnings. There have been eight years of dividend cuts since 1940, versus 22 years in which earnings declined.
Finally, dividends can provide an effective inflation hedge. Dividend income has grown at least in line with (and often faster than) inflation.
These powerful factors mean that, whatever global markets do, we believe in harnessing good value quality companies with growing dividends.
So why now?
Economic forecasting is a famously bad science even in the good times. In the unknown territory of the post QE world, there are only two things one can point to with any confidence: inflation, and rising interest rates. So what to own in your portfolio?
Rising interest rates are clearly bad for fixed income investors, but they’re bad for growth-style equity investors too.
A lot of the supposed value of growth/momentum companies is derived from future estimates of cash flows. Rising interest rates potentially threaten these companies’ long-term margins, as higher interest rates can push up their cost of capital.
By contrast, a lot of ‘quality’ companies have been able to refinance their long-term debt at exceptionally low levels. For example, in 2013 Microsoft sold $750 million of 10-year bonds with a coupon of 2.125%, and $900 million of 30-year bonds at 3.5%. Considering that 10-year US government Treasuries were trading with a yield of 1.6% at the time, it implied a credit spread of just 0.525% for Microsoft’s 10-years bonds. Locking in such good terms should provide some protection in the event of rising rates, and may potentially give them an advantage over their competitors. Any impact of rising interest rates on these high quality companies is going to be very modest.
Our approach to Global Equity Income combines quality and value, and focuses on companies that achieve top quartile returns on capital every year throughout an entire business cycle – this is our definition of ‘quality’. We then seek to narrow down this list further to identify those companies that we believe offer good value, and in particular where valuations sit relative to industry peers, relative to their own historic valuations, and to the broad market in general.
This gives us a portfolio of good value dividend payers with unusually persistent earnings – a staple for any portfolio, and a must have amid rising interest rates.
(Note 1 - S&P500, average of each annual 20 year period from 1940).