The importance of the dividend has taken a back seat. The dominant theme in the market is technological disruption - and for the disruptors, the payment of a dividend could not be farther from their thoughts.
What is your investment outlook for equity income in 2018?
When asked about prospective returns from our asset class we tend to frame our answer by acknowledging the three building blocks of total return:
- dividend growth, and
- valuation change.
For my approach, I feel I have a good line of sight on the first two of these: the dividend yield is currently near 3%, and we see the companies in the portfolio growing their dividends on average at 4-5% per year. These two components together produce an attractive total return of 7-8%, in line with long term equity returns.
However, over short investment horizons (such as a calendar year) the wild card is valuation - and, at a time when starting valuations are so high and interest rates are rising, I feel the risk is to the downside. My holdings will not be immune to a broad based multiple contraction, whether driven by higher inflation or real risk-free rates, but our valuation discipline can offer some protection.
On a basic price to earnings (PE) multiple, the portfolio trades at c.16x versus the market at above 19x. This valuation discount, alongside the superior cash conversion of our holdings and a focus on the balance sheet, should serve us well in a less accommodating market environment.
What do you think could most surprise investors next year?
While it is tempting to cite the direction and speed of interest rate moves as likely to catch investors by surprise, I see a reasonably wide range of opinion here, making a ‘surprise’ by definition less likely. On other issues, market opinion is much more one sided.
Lack of operational gearing into an upturn
We are witnessing a period of synchronised global growth, with lead indicators strong and strengthening. The market has reacted by valuing cyclicals (businesses most exposed to stronger economic growth) on multiples which anticipate strong profit growth.
While higher cyclical valuations would normally follow higher growth expectations, I feel that there is room for disappointment. Profit margins are already high and there is a potential for cost pressure from both wage and commodity price inflation. Furthermore, technological disruption is eroding pricing power across many industries.
All this combined may mean that strong economic growth does not feed through to corporate profits to the extent that we have become used to in prior cycles.
The re-emergence of volatility
It is noticeable that some significant ‘surprises’ over the last few years, whether political or economic, have not translated in to turbulence in the equity market. The danger is that this leads to complacency.
To the extent that investors equate volatility with risk, a prolonged uptick in volatility could become self-reinforcing. After such a long period of calm, this would take many by surprise. For stock pickers like me, it could provide the opportunity to profit from any indiscriminate and outsized moves in prices.
Chart 1: Volatility has been calm for a long time
Source: Datastream, 10 November 2017
How do you plan to capture the best opportunities and add value for investors?
Our strategy is a consistent one - aimed at delivering an attractive risk-adjusted, dividend-based total return. We do this by identifying and investing in good companies at reasonable valuations.
The focus on valuation and the dividend means many of the ‘disruptors’ are beyond our remit but this does not mean we ignore them.
Chart 2: Disruptors are expensive and have low dividend yields
Source: Fidelity International, 31 October 2017
I spend a lot of time questioning whether the changing landscape the disruptors bring will affect the resilience of the businesses I own. New technologies can bring down barriers to entry, erode industry profit pools, and may even render some business models obsolete. Examples of industries affected include telecommunications, retail, and media/advertising agencies.
This is where I can add value; making sure I do not give in to the siren call of a high dividend yield if the underlying franchise is under threat from these disruptive influences. Avoiding these ‘yield traps’ will help me deliver the sustainable income that will ultimately drive returns.
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