The Compelling Case for Equity Income

Key Points

• With the potential for slower growth and lower capital returns from equity markets, making the income component of returns more significant, we believe the backdrop for dividend-focused equities is favorable.
• As dividends tend to be more stable than markets, company profits or economies, we think a focus on the dividend income can provide a more durable dimension to any investment strategy seeking to navigate challenging or volatile markets.
• Nevertheless, it is important to be selective: companies that are over-distributing to shareholders and underinvesting in their business can harm fundamental prospects and jeopardize the sustainability of a dividend.

After more than a decade in which markets have been dominated by growth, investors could be forgiven for overlooking the benefits of dividend-focused equity strategies. Until very recently, many of the leading technology stocks were on valuations that implied the growth they would experience as large companies would be almost as rapid as their historic trajectory. Some investors committed capital to areas that appeared to offer almost boundless opportunities, such as cryptocurrencies, private equity and parts of the property market.

However, over the last 12 months it has become increasingly clear that market participants need to face up to a very different regime. Rising interest rates and high inflation have created an extremely challenging environment across all major asset classes. Many of the high-growth technology-related stocks that were the big winners over the last ten years, and particularly during the Covid pandemic as we all worked and shopped virtually, have seen precipitous declines. Areas of the economy where speculative bubbles have formed – such as private equity and cryptocurrencies – have started to look increasingly vulnerable as the tide goes out.

Many investors may be hoping that their current portfolio will lead them out of the downturn, but while history may not repeat itself, a look back at previous cycles suggests to us that market leadership can change dramatically in such instances. Internet and telecoms stocks, for example, formed the dot-com bubble in late 1999, but did not lead the recovery when the market finally found its bottom in 2003.

With the potential for slower growth and lower capital returns from equity markets, making the income component of returns more significant, we believe the backdrop for income stocks is favorable. Post Covid-19, balance sheets have been repaired and although dividends have recovered, earnings have recovered faster, so payout ratios have come down and dividend cover is pretty good.

Inflation Protection and Attractive Valuations

Taking a long-term view, it is noteworthy that during previous inflationary periods, income stocks have proved an attractive proposition for investors looking for inflation protection and defensiveness at a reasonable price. While we may have reached peak inflation and appear to be nearing a high in global interest rates, we do not expect interest rates to start to come down quickly, despite some market participants’ apparent clamor for a pivot from the US Federal Reserve. Instead, we expect inflation to prove relatively sticky in response to long-term trends such as deglobalization, decarbonization and rising wages.

We believe another supportive factor is the attractive valuation of income stocks. At the time of writing, above-average-yielding stocks trade at a substantial discount to below-average-yielding stocks on price-to-earnings and price-to-book bases. Even after a period of much better performance from income stocks in 2022, we see them as inexpensive relative to non-income stocks. In our opinion, this is because investors are keen to do what they have always done (at least in the years since the 2008 global financial crisis), which is to own growth equities.

However, when considering the desired investment outcome, we think investing in income equities could often make more sense than a growth or value-centric approach. Beating the Nasdaq is unlikely to be the right objective for a retiree in their 60s or 70s who is looking to protect their portfolio from inflation risk. As dividends tend to be more stable than markets, company profits or economies, we think a focus on the dividend income can provide a more durable dimension to any investment strategy seeking to navigate challenging or volatile markets. Nevertheless, individual investors may be deterred by industry platforms which in many cases only highlight the capital gain realized from an investment, rather than showing the total return which also includes dividend payments over a period.

To the long-term investor, attractive equity returns are derived not simply from the receipt of dividends, but from the accumulation of shares as a result of the reinvestment of those dividends. Over the very long run, the impact of dividend reinvestment on total returns is extraordinary; since 1900, 99% of US equity total return has been driven by dividends and their reinvestment.[1] As Albert Einstein said: “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it”.

Focus on Dividend Sustainability

Not all equity income investing is the same, however. Without being selective, there is a danger of gaining exposure to higher-yielding stocks that may be unable to sustain their dividend payments. Clearly, companies that are over-distributing to shareholders and underinvesting in their business can harm fundamental prospects and jeopardize the sustainability of a dividend, as well as undermining the potential to grow that dividend. In this context, we believe it is important to focus on careful analysis of each individual security, looking at each investment prospect from all relevant angles. Does a company have the structural and thematic support to sustain its dividends and grow its business? Does it have the right governance structures, and are there any environmental or social factors that ultimately call into question the long-term sustainability of its dividends?

As we enter a new investment era likely to be defined by uncertainty and volatility, we believe an active, discerning approach to equity income could be key in helping investors achieve attractive outcomes.

[1] Source: Professor Robert Shiller, Yale University, August 2020. Credit Suisse, Global Investment Returns Yearbook (2011) and Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the optimists: 101 Years of Global Investment Returns (Princeton University Press, 2002), with updates from the authors; February 2012. Copyright © 2011 Elroy Dimson, Paul Marsh and Mike Staunton.

Authors

Euan Munro

Chief executive officer