Yield, growth and valuations
However, it is reasonable for clients to ask us about what might drive returns in the future.
When addressing this question, it can be helpful to break the sources of investment return into three components - yield, growth and valuation change.
The portfolio is currently producing a yield of around 3.3% (gross), compared to around 2.5% for the global stock market. Our analysis suggests that our income distribution should grow by around 6% over the next year. Given the defensive and predictable characteristics of the businesses in which I invest, we can have relatively-high conviction in the income that the portfolio provides.
However, it is much harder to estimate how valuations across the market may change in the coming year. Investor optimism and accommodative monetary policies have driven valuations higher in recent years, particularly in the US.
These high starting valuations leave some areas of the market vulnerable to a de-rating, as interest rates rise. If sentiment weakens, we could see the return of volatility and drawdown to some sectors, which have been the most popular with investors over the past few years.
Our first line of defence against a de-rating in the market is our valuation discipline. Our portfolio currently trades at a significant valuation discount to the broader market and crucially, this value is underpinned by high quality, defensive businesses. Ensuring that we don’t overpay for businesses should help us to preserve our client’s capital should we enter a more difficult market environment.
Sustainable income investing likely to outperform
One question that regularly comes up is whether equity income strategies can outperform in an environment where interest rates are expected to rise. The logic behind this question is that dividends will become less valuable to investors if higher yields are available in bonds.
This appears to be a widely-held view in the market and is therefore worth challenging. There are three key reasons why I think our style of sustainable income investing could outperform.
1. Valuation discipline
Valuations reflect expectations, which have changed substantially since the ‘lower for longer’ regime that ended in mid-2016. Lower starting valuations for dividend stocks suggest an attractive balance of risk and reward, and will help to provide investors with a margin of safety. This is one of the reasons that dividend strategies tend to outperform during more difficult market environments.
2. Real income growth
Bond coupons are fixed and therefore decline in real terms during inflationary periods. Dividends, on the other hand, can grow and therefore keep pace with inflation. However, not all companies have the competitive strength to pass on higher prices and defend profit margins.
Some stocks trade at high dividend yields because the market is discounting a lack of pricing power, which does not augur well for dividend growth. We prefer to own valued businesses that we believe have the competitive strengths and resilience necessary to consistently grow dividends across different macroeconomic environments.
3. Debt to come back into focus
During times of easy money, markets become complacent about debt. In recent years, many companies took advantage of low borrowing costs to use cheap debt to buy back shares or pursue mergers and acquisitions. Aside from the fact that most large-scale M&A activity tends to destroy shareholder value, highly-geared companies should now find financing this debt is more expensive as interest rates rise.
Management teams aiming to deliver progressive long-term dividends tend to venture more cautiously into debt markets and run businesses with more modest levels of gearing. This is because debt is senior to equity in the capital structure, so heavy debt burdens can quickly impact a company’s ability to pay its dividend if times get tough.
Taking all this together, it seems like an oversimplification to say that quality dividend-paying stocks will underperform in a rising rate environment. Other factors, such as starting valuations, and the reasons why rates are rising, also need to be considered.
Could 2019 prove to be the year in which investors revisit their predictions and rediscover the attractiveness of defensive equity income strategies?
After all, Dick Rowe of Decca Records eventually revised his opinion on guitar music and signed the Rolling Stones to his label - a decision that worked out well for him financially.