When thinking about future returns from global equity markets, it can be helpful to break the sources of investment return into three components: yield, growth and valuation change. The sum of these three components gives an investor their total return.
In very good years, for example 2017, a positive return will come from all three components. Last year, however, we saw a significant multiple compression due to a combination of rising US rates and the emergence of a more negative narrative around the health of the global economy. This resulted in an overall negative return from global equities in GBP terms last year, despite a positive contribution from earnings and dividends.
Interestingly, as the US Federal Reserve continued to raise rates in the fourth quarter, high-dividend strategies generally outperformed the broader market, which challenges the consensus assumption that rising rates lead to the underperformance of dividend-based strategies.
In terms of what may lie in store for investors over the coming months, given the uncertain outlook around valuations and growth, I think it makes sense to emphasise dividends as a component of total return, and to do so by investing in assets that trade at an attractive yield and will be well-supported throughout a range of economic scenarios.
Looking past the headline yield for a margin of safety
It is important, however, to look beyond a high headline yield and hone in on those companies that possess the quality and resilience to deliver sustainable dividend growth over time. As a result, I do not simply invest in the highest yielding or cheapest companies, as a high headline yield can often be a sign of stress in the underlying business.
So, while I place significant emphasis on the price I am being asked to pay for a stock, I also demand certain characteristics from companies – such as a strong balance sheet, predictable cash flows and management that recognises the importance of good capital allocation – to help provide clarity over a stock’s true value and sustainability of its earnings and dividend.
In the case of the Fidelity Global Dividend Fund, this approach results in a portfolio that is cheaper than the market on a dividend yield and free cash-flow yield basis and similarly valued in terms of price/earnings ratio. However, the quality of the assets in the fund is higher than the market, with more resilient return profiles and a lower level of debt.
Revenues in sectors such as pharmaceuticals, consumer staples and utilities tend to be consistent over a cycle, meaning cash flows can grow even if the broader economy is slowing. Companies in these areas are therefore typically less sensitive to fluctuating levels of demand in the economy.
In terms of how this plays out at the individual stock level, I have a long-standing position in Dutch professional services company Wolters Kluwer, which was the fund’s top contributor in 2018. Notably, the stock does not offer a high headline yield, as it has a low pay-out ratio, but it has been slowly growing its dividend for several years. I see potential for this to pick-up as its move from print to digital completes and it continues to generate strong recurring revenues and stable cash flows. During 2018, it delivered organic growth ahead of expectations, leading to a strong share price performance.
Elsewhere, the fund has had more limited exposure to some of the more cyclical areas of the market, such as materials, capital goods, energy and banks. However, after a sharp fall in 2018, it is important to recognise valuations in cyclicals are now significantly lower. Late last year, I began to deploy capital into areas where it is possible to find high quality companies that possess the competitive and financial strength to prosper across cycles. It was possible (albeit for a brief period) to find such companies whose share prices had fallen more than 30% from their 2018 highs.
Dividend yield: The dividend per share, divided by the price per share.
Free cashflow: A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base.
Payout Ratio: The proportion of earnings paid out as dividends to shareholders.
Price Earnings (P/E): A valuation ratio of a company's current share price compared to its per-share earnings.
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Please note that Tom’s picks are not a personal recommendation for you. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.