There are a couple of (related) subconscious assumptions that investors seem to hold today. The first is that we are in a low return world, and the second is that investing for income is harder today.
Both of these beliefs are ultimately driven by the very low levels of government bond yields. As Stuart wrote last year the idea that we are in a low return world doesn’t stand up to scrutiny if we look at the returns that have actually been delivered, and only works as a forecast (albeit one based on valuation in many cases).
What about the idea that income is harder to come by?
It is true that areas of the fixed income market that income investors have historically relied upon are now trading at extremely low yields. This not only reduces their absolute attractiveness but, as I discussed last week, also influences their risk properties.
There is therefore a challenge for investors seeking income in developed markets like the UK and Germany who may previously have relied upon domestic government bonds (though those already holding the bonds will have received significant capital gains). But this would be to ignore a number of positive developments over the last ten years for investors with a broader universe.
Far more opportunities for income within equities today
Much has been made of the “hunt for yield” since the financial crisis and its negative implications. We have sympathy with this view; looking at headline yields without consideration for risk has always been and dangerous approach.
However, another impact of increasing demand for income has been on the behaviour of corporations. As the markets have rewarded companies showing more discipline so CEOs have looked to enhance their dividend policy. The chart below shows the number of companies in the world with at least a three year history of growing dividends.
As may be expected, the number of companies that were able to maintain this history dropped after the financial crisis, but consistent additions to the universe mean that there are far more companies to choose from today than prior to the crisis.
Importantly, these companies are also spread globally. It has long been the case that investors looking for companies with quality balance sheets and a history of dividend growth had to focus on the US, and to a lesser extent Europe. Figure 2 shows the countries which had at least 20 stocks with a three year dividend growth history in 2007.
By 2017, we can add six new countries to this list, while only Finland and Belgium have dropped out.
The map is flattered by the geographical size of Russia and Brazil, but it is worth noting that the new regions also include Mexico, Indonesia and the Philippines- significant economies with large populations. At the same time, parts of Asia which have traditionally been less shareholder friendly than other parts of the world are showing significant changes in culture. This is most notable in Japan where Abe’s third arrow is arguably shaping corporate behaviour in a positive way for investors, including higher dividend payments.
Are these new opportunities more risky?
A common criticism is that the hunt for yield has reduced dividend yield on quality stocks to dangerously low levels. Even if there are more stocks to choose from, are they all more risky? Our view is that this is not the case in all areas; it is important to discriminate between those companies that have be re-rated significantly simply for having stable earnings and those where earnings and dividend payments have continued to grow.
In fact a simple screen based on dividend yield and history of growth in dividends suggests that valuations remain reasonable and that dividend growers have on average a better debt profile than they had back in 2007 and a better valuation in terms of both price to cash flow and price to book.
It is also the case that, in aggregate, dividend yields look relatively elevated (the spikes below are due to the stock price declines of 1990 and 2008).
The question naturally arises: if companies are focusing more on dividends (and buybacks) does this come at the expense of growth opportunities? It remains to be seen if this is the case in aggregate, current earnings delivery and expectations look reasonably normal though capital expenditure (as measured) has been weak, and for the most part there seems to be adequate compensation for this risk.
Outside of equity markets
Of course even equities that pay a growing dividend can be more volatile than many income seekers would demand. They also have the propensity for high correlation in times of stress even across geographical borders.
Fortunately for multi asset investors, there is scope to add a range of attractive income bearing assets. Our colleague Richard Woolnough wrote last year about the evolution of the corporate bond market in the UK and beyond, which is even more encouraging than my observations on the equity market above. For those who are able to be selective, there are far more options available today than ever before. This has only been enhanced by the ongoing development of ‘alternatives’ assets which offer new means of accessing areas of the investment universe such as property and infrastructure.
A wider investment universe should mean a greater opportunity for diversification but also a greater need to be selective. In last week’s piece I mentioned those areas of fixed income that offer a potential margin of safety against rising rates in the US. However, even apparently ‘alternative’ assets (many of which have not been around long enough to be tested by rate increases) could well be sensitive to rate movements and liquidity pressures.
Income as a style versus income as and an outcome
Much of the concern about the ability to generate income is driven by very low government bond yields as well as the fear that naturally arises when a particular ‘style’ or theme has done particularly well. It is almost certainly true that the success of income as a style is a major driver of the ‘fashion’ for income investing, which has driven some valuations to risky levels.
However, for those who genuinely need a regular income stream such as retirees or institutions with fixed liabilities, the benefits of a developing universe of income bearing assets far outweighs the negatives.
There is a greater need for selectivity, but this was always the case, and for multi asset investors there are more options available than ever before. Moreover, as yields continue to rise in many parts of the world so far this year, it could just be the case that the traditional income sources might return to be more attractive as well.