- Dividends are a significant driver of total return in global equity markets.
- Established dividend cultures in developed markets and the growing popularity of dividends in emerging markets support consistent income generation.
- We believe an investment approach that targets high current income and dividend growth is well suited for normalizing global markets.
While the long-term advantages of dividend investing are well documented, recent policy uncertainty and underperformance of international markets have caused many investors to question the relative attractiveness of income strategies. We believe these concerns, though valid in the recent past, overlook the long-term income advantages and risk management benefits of taking a global, valuation-centric approach to dividend investing.
Dividends and dividend growth have accounted for an overwhelming majority of stock returns over time, both in the U.S. and globally. Dividend yield and growth have generated nearly all the total return for stocks in the United Kingdom (UK) and France since 1970, according to SG Cowen Cross Asset Research, while stocks in Germany, Canada and Australia have also been highly dependent on dividends. Reinvestment of dividends further compounds investor returns. Over the past 25 years through the first quarter of 2018, notional returns for the MSCI World Index were 8.3% annually including dividend reinvestment, versus 5.9% without. Fundamentally, we believe that dividend commitments are strong guideposts for management teams with respect to efficient capital allocation and shareholder returns.
In the years following the global financial crisis, central bank suppression of interest rates made a strong case for dividend stocks, as they offered more attractive yields than other fixed income alternatives. Exhibit 1 shows the gap between equity dividend yields and bond yields across regions. However, as policy begins to normalize, particularly here in the U.S., fear exists that income stocks will fall out of favor. While rising interest rates create additional alternatives for yield, we believe stocks remain more attractive than bonds due to their inflation protection features. Companies have more flexibility to protect future cash flows through pricing power and growth initiatives, i.e. stocks have a better chance of growing their dividends in line with or above the rate of inflation versus the nominal fixed coupons of bonds.
Exhibit 1: Dividend Yields Remain Higher than Bond Yields in Select Markets
Regional Markets Maintain Strong Dividend Culture
Although the U.S. Federal Reserve has shifted to a tightening posture, central bank policy in other major regions such as the European Union (EU), Japan, and the UK remain accommodative. Hence the yield advantage of dividend stocks remains very compelling in non-U.S. markets. Additionally, valuations and growth rates differ significantly by region, so a global investment mandate gives a portfolio flexibility to capitalize wherever the best contrarian opportunities may be. Lastly, dividend payout practices vary significantly by country (Exhibit 2), and the ability to invest globally offers a better selection of high yielding stocks. For example, dividend imputation (which eliminates double taxation on dividends) in Australia and New Zealand have resulted in world-leading payout ratios by companies in that region. Many countries in Western Europe and the UK also previously offered dividend imputation. Although this practice has since ended, investor preferences for dividends remains high due to historical practices.
Exhibit 2: Payout Ratios Are Lower in Asia
Emerging markets (Exhibit 3) and Asia have also demonstrated strong dividend growth over the past 15 years. Although the starting point is lower, this trend is likely to continue given the strong growth rates and falling capital intensity in these regions.
Exhibit 3: More Emerging Markets Companies Are Paying Dividends
Global dividend investing generally follows one of two philosophies. One is the quality income camp, which focuses on high current yield when selecting dividend stocks. The goal of these strategies is to be a low volatility safe haven, particularly in market downturns, and thus these income strategies are usually filled with low beta stocks from the consumer staples, telecommunication services and utility sectors that pay high, bond-like coupons. However, companies in these areas generally have low growth businesses with less upside sensitivity to an economic upturn. Conversely, the other philosophy toward dividend investing embraces a dividend growth bias. Current dividend yield does not necessarily need to be high, but the potential for growth of the business (and the corresponding dividend payout) creates an attractive case for investment, particularly during market upcycles.
Targeting Current Income and Dividend Growth
At ClearBridge, we believe that both philosophies have merit, and we seek to build a balanced portfolio of stocks in our Global Equity Income Strategy which incorporates both high current income as well as future income growth. The key, however, is being disciplined and opportunistic with respect to valuation at time of purchase. As with all our international and global value portfolios, our investment process starts by harnessing a quantitative model to identify stocks trading at abnormally low valuations. For Global Equity Income, we then apply a second set of dividend-focused screens, looking for characteristics such as a history of consistent/uninterrupted dividends above our minimum threshold, high total enterprise yield (which include debt and share buybacks) and companies forecast to grow dividends at an above-average rate. Stocks must pass multiple dividend screens before they are considered for purchase. The goal is to identify companies trading at low valuations which have the ability to deliver not only solid yield today, but also have underlying growth and stability in cash flows to grow that income into the future.
To illustrate, we recently purchased shares of German broadcaster Prosiebensat Media. The company operates in a stable duopoly and was the growth darling of European media up until 2016. Concerns around the health of German television advertising, combined with uncertainties over a new CEO, caused the shares to halve, enabling us to buy the stock at 10x earnings with a 7% yield. We believe that the underlying business is healthy, the German television market is recovering and the new CEO will reinvigorate the company’s position in digital/online. Similarly, we also made a recent investment in Thai Union Group, a global leader in frozen and ambient seafood. The company was hampered by high input (tuna) prices and strong FX headwinds (from the Thai baht) in 2017, but we see both subsiding this year. We purchased the shares at a reasonable multiple coming off depressed earnings with an over 3% dividend yield. Longer term, the secular demand for seafood protein remains very strong, driven by rising disposable incomes, urbanization and health concerns, leaving the company well positioned to grow its dividend.
We believe global dividend investing is currently attractive and can remain so throughout the market cycle, if guided by a disciplined, valuation-centric process. As contrarian income investors, recent market volatility is creating opportunities to buy high-quality dividend growers at discounts to intrinsic value, primarily due to macroeconomic concerns. As market conditions normalize, particularly in out-of-favor segments such as international and value stocks, we expect our approach of balancing high current yield with dividend growth can provide compelling long-term opportunities for income investors.