- The specter of rising interest rates continues to haunt markets.
- Over very long periods of time the performance of growth and value have been substantially the same.
- Our emphasis on compounding dividends focuses our investments in companies with earnings growth, which over time drives both increasing income and capital appreciation.
Market Overview and Outlook
The second quarter was another challenging quarter for equity income investors. The specter of rising interest rates, discussed in our first-quarter letter, continues to haunt markets. Additionally, higher-growth stocks, most of which do not pay dividends, completely decoupled from the rest of the market.
Over the last 18 months growth stocks have risen nearly 40%, while value stocks have grown just 12%. A disparity like this has not been seen since the tech bubble nearly 20 years ago. Through January 2018, the styles at least moved in the same direction — up. Since the selloff in January, however, growth has recovered substantially, whereas value has lagged. In the first six months of 2018 the Russell 1000 Growth Index is up 7%, while its value counterpart is actually down more than 1%.
The ClearBridge Dividend Strategy does not fit neatly into either a value or growth category — we straddle elements of both styles. Our focus on dividend payers confers a value element — most “growth” companies do not pay dividends. But our emphasis on compounding dividends focuses our investments on companies that can sustainably grow their earnings, and therefore their dividends as far as the eye can see. But no matter how you slice it, we are a dividend strategy. And as Exhibit 1 shows, over the last 18 months there has been an inverse relationship between dividend yield and stock performance.
Exhibit 1: Dividend Yield and Stock Performance 2017–2018 (YTD)
The underperformance of dividend payers is largely attributable to the factors we have highlighted so far: rising interest rates and the terrific performance of growth stocks. As interest rates move higher, the prospective returns of securities become relatively less attractive and their prices decline to align their returns with the higher interest rate environment. This dynamic affects the valuation of all investments, but it weighs most heavily on investments with little to no growth. The fixed nature of this income stream leaves the security’s price as the only factor that can adjust to equilibrate.
All else being equal, higher-growth stocks are relatively better positioned for rising rates. Rising cash flows provide an additional adjustment mechanism beyond simply the security’s price. We generally expect our portfolio companies to grow their dividends meaningfully. This growth should provide a significant offset to rising rates. While this factor has been overlooked by the market of late, we expect it will be more appreciated in the fullness of time.
Most of the highest-growth stocks do not pay dividends. As such, they are not particularly suitable for Dividend Strategy. None of the Internet titans (Amazon, Facebook, Google, Netflix) pay dividends; on average they are up over 100% over the last 18 months, and all have been huge contributors to growth indexes and the market. Collectively, these securities are responsible for 18% of the return of the S&P 500 and 20% of the performance of the Russell 1000 Growth Index.
With the ubiquity of technology and its ever-accelerating pace, it is tempting to assume growth will outperform in perpetuity. This is certainly possible. We have no crystal ball here at ClearBridge, but a look back in the recent past demonstrates just how anomalous the recent divergence really is between growth and value and between income and non-income. From 2010 to 2016 growth and value performed in line. Over that timeframe there was also no relationship between performance and yield (Exhibit 2).
Exhibit 2: Dividend Yield and Stock Performance 2010–2016
Until just 18 months ago growth and value were performing similarly. Nothing has changed in the interim to suggest the outlook for growth stocks has radically improved, but the stocks have completely re-rated. Again, we are not making a call that growth is set to roll over. We simply point out that over very long periods of time the performance of growth and value have been substantially the same. Periods of great discrepancy have proven to be ephemeral and meaningful extremes in performance (both under and over) have tended to revert to the mean. Exhibit 3 compares the performance of value and growth going back all the way to 1980.
Exhibit 3: Growth and Value Stocks Over Time
Dividend Strategy is designed for the long term. Our portfolio of high-quality dividend payers protects capital in down markets. Our emphasis on dividend growers drives strong growth in income, which over time drives capital appreciation. Amid today’s backdrop of geopolitical uncertainty, a maturing market cycle and rising interest rates, we think Dividend Strategy is well positioned.
The ClearBridge Dividend Strategy underperformed its S&P 500 Index benchmark during the second quarter. On an absolute basis, the Strategy had gains in seven of the sectors in which it was invested for the quarter (out of 11 sectors total). The main contributors to Strategy performance came from the information technology (IT), energy and consumer discretionary sectors, while the main detractors came from the financials and industrials sectors.
"Recent divergence between growth and value and between income and non-income is a large anomaly."
On a relative basis, sector allocation detracted from performance for the quarter. In particular, overweights to the consumer staples and financials sectors and an underweight to the IT sector detracted from relative results. Stock selection in the consumer discretionary sector also dampened relative returns. Meanwhile, stock selection in the consumer staples was a significant positive contributor to relative performance.
On an individual stock basis, the largest detractors were Berkshire Hathaway, 3M, Travelers, Raytheon and Johnson & Johnson. Positions in Microsoft, Home Depot, Apple, Merck and Mastercard were the greatest contributors to absolute returns in the second quarter.
During the quarter, we initiated positions in PNC Financial Services in the financials sector and Suncor in the energy sector. We sold our position in Pentair in the industrials sector, as well as nVent Electric, which spun off from Pentair during the quarter. Our holding of Time Warner was converted into shares of AT&T, which we maintained.