Dean Cheeseman and Nick Watson, fund managers with Janus Henderson's UK-based Multi-Asset Team, discuss why focusing on income could be a beneficial strategy for longer-term capital returns.
Historical data shows that dividend yield and dividend growth have been the strongest drivers of equity returns over the long-term. The chart below illustrates just how influential income has been across a number of developed markets over a 45+ year time period.
Chart 1: Dividend yield has driven long-term equity returns
Source: Thomson Reuters Datastream, Janus Henderson, and Société Génerale Cross Asset Research, quarterly data from 1970 to Q2 2017, rolling ten-year average real (inflation-adjusted) returns. Multiple expansion relates to rising price-earnings multiples. Please note that past performance is not a guide to future performance.
Q. Why has focusing on income driven returns?
There are a number of reasons why income investing within equities has been an advantageous strategy over a long-term period:
Generating a sustainable income is highly correlated with a business being well-managed and profitable. The ability to generate stable returns and offer greater resilience to market volatility should also make that business easier to forecast.
- Identifying well-managed and profitable businesses
For income to be relevant it must be generated from a company's net operating profits. A policy of raising debt to pay shareholders is typically unsustainable and weakens the overall business. Returning a regular and ideally growing income is a sign of a healthy cash-generative business. The discipline of returning cash to shareholders is also a sign of good stewardship by management and often robust governance. Dividends are paid in 'physical' cash from earnings or retained earnings and cannot be manipulated by accounting techniques. These characteristics of profitable and well-managed businesses can also be described as 'quality' factors/premia and academic research has shown 'quality' to be a long-term driver of excess returns.
- Sustainable income has tended to lead to greater stability of returns
Companies that distribute a sustainable income tend to generate repeatable cash flows, which are likely to lead to greater asymmetry in returns (i.e. more likely to produce a positive skew). Generating a sustainable income is highly correlated with a business being well-managed and profitable. The ability to generate stable returns and offer greater resilience to market volatility should also make that business easier to forecast.
- Income investing can offer a hedge against inflation over the longer term
Whilst equities per se can offer inflation protection over the longer term, the growth of dividends paid generally outpaces the inflation rate. Unlike shorter-term inflation hedges, i.e. inflation-linked bonds that are poor performers if the inflation risk being hedged fails to materialise, equities that pay out a sustainable income should capture much of the market upside when inflation is less prevalent, and may outperform when inflation becomes more persistent.
- Benefits from pound cost averaging
In a falling equity market, thanks to the reinvested dividends being added at lower capital levels, the average purchase cost for the investment is reduced. Typically, in an economic downturn, dividend paying companies will continue to return cash to shareholders, even after corporate earnings start to fall.
- Income investing can identify companies that have value characteristics
Companies that distribute a steady income to shareholders often trade at a discount to the broader market, because of a number of fundamental and behavioural reasons. Cash flow positive businesses are generally mature and 'ex-growth', whereas the market assigns a premium to faster growing companies. The market also often underestimates the benefits of the long-term compounding generated by steady income by focusing too much on the shorter-term growth outlook.
Q. What about income investing in the short term versus the longer term?
Over a longer time frame, the key influence to a market's price-to-earnings (PE) ratio is inflation, and the key financial metric associated with inflation is the long-term interest rate. PE ratios are inversely correlated with interest rates, falling when rates rise and rising when rates fall. Currently, we are seeing stretched PE ratios and record low interest rates, largely as a result of QE. But looking forward, the US and UK have now moved into an interest rate tightening phase (albeit very gradual), which should see PE ratios begin to moderate. Over the shorter term, if equity markets are going to deliver positive returns, it is likely that this will be driven by dividends rather than PE expansion.
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