Global Equity Investing:
Investing for dividends and dividend growth
This document is for Professional Clients only and is not for consumer use
Invesco Perpetual Global Equity
Income Group
This paper looks at equity income investing; why dividends matter and
what opportunities exist in a low interest rate world.
Income investing, a value approach
Investing in an equity income style is a value approach to investing. When it comes to
dividends, we believe that:
–
–
–
–
They are an important component of total return
Growing dividend streams are worth more than high static yields
Dividends must be sustainable to be valuable
Dividend behaviour is a signal of management confidence
What is equity income investing?
We believe that equity income investing is about building portfolios which, in
aggregate, exhibit above market dividend yield and, just as importantly, underlying
dividend growth. The powerful combination of dividend yield and dividend growth has
been known to investors for decades, with research to support the notion that this
combination can produce above market average returns1.
However, it would be unwise to discount the risks of focusing solely on high dividend
yield. A dividend yield can appear high (albeit temporarily), when a company becomes
distressed. The combination of a falling share price paired with an historical dividend
payment can create an attractive illusion. This illusion tends to be most dangerous around
periods of economic crisis. It is for this reason that dividends must be considered in the
context of a business’ ability to sustain and pay that dividend into the future.
As per figure 1, a study by Credit Suisse shows that on average, the lower the payout
ratio (the amount of earnings that are paid out in the form of a dividend), the better the
performance of companies has been. And within each payout range (i.e. low, medium
and high), companies with a high dividend yield have, on average, outperformed
companies with a low or medium dividend yield. Capacity to pay the dividend is clearly a
critical factor. The best combination on average (+15.8% per annum) over 15 years has
been high dividend yield with a low payout ratio.
For many, equity income investing is not about receiving the income, but reinvesting
the income received and allowing the power of compounding to drive their total return.
Why do dividends matter?
In theory, a company’s decision to pay
a dividend should not alter the intrinsic
value of the business. This is known as the
dividend irrelevance theory – first proposed
by Miller & Modigliani in the 1960s.
In practical terms, dividends are a rather
more powerful contributor to stock
performance. The theory relating to why a
company that pays and grows its dividend
tends to outperform centres on the idea
that a dividend is a signal of management
confidence. The idea of signalling was first
discussed in 1973 by Nobel Prize winning
Economist Michael Spence. This and
subsequent work identified the proposition
that asymmetric information in equity
markets means the dividend can provide
a ‘signal’ to markets of management
confidence. Over time, academic research
including that by Miller and Modigliani
(1985) has supported the idea that
because of information asymmetry, stocks
outperform after a dividend rise and
underperform after a dividend cut.
Research by Aharony & Swary (1980) also concluded that firms which increased their
dividends experienced, on average, higher subsequent earnings growth. Concurrently,
firms that decreased dividends experienced lower subsequent earnings growth. The
idea that earnings growth can be higher for companies that raise dividends is contrary
to the perception about dividend-paying companies generally. However, the evidence is
supportive that dividends are not a signal that a company has gone ex- growth and has
no alternative use for their cash flow.
As investors, we believe that dividends exert discipline on companies, in that they represent
a periodic cash payment. It is this discipline that we see as linked to wider corporate
discipline and as the empirical evidence supports, higher long-term earnings growth.
The compounding dividend effect
Much is made of the power of compounding. For investors in the equity market, we
know that the long-term annualised return of the equity market over 20 years has
been approximately 7.7%2, however, that return has not been delivered smoothly
through time. The volatility of the market return can be high, versus the volatility of the
dividend, which is generally significantly lower.
Over the last 40 years, the annual return of the broad global market index, the
MSCI World, has vacillated between -42% (2008) to +34% (1986). This compares to
dividends, which over the same period moved between -17% (2009) to + 14% (1978)
annually. If the Great Recession of 2007 to 2009 was excluded, the worst fall in actual
dividend in a single year was -4% (2001)3 over the last 40 years.
In 2000, the dividend yield of the MSCI World was a mere 1.2%, versus the 2.5% currently.
Nonetheless, the compounded value of that 1.2% dividend over the last decade turned US$100
into US$132 as shown in figure 2. During this same period the capital appreciation of the equity
market would have turned US$100 into US$120.
Figure 1
Annualised total return
Dividend yield and payout ratio – January 1990 to December 2014
Dividend Yield
HighLow
Payout ratio
High/NegativeLow
-0.5%
1.7%
4.5%
6.5%
9.4%
10.3%
11.4%
14.2%
15.8%
Source: Credit Suisse HOLT, February 2015. Universe: Largest 1800 global stocks
by market cap
Figure 2
Dividend contribution to total return
MSCI World index 2000 to 2014
00
01
02
03
04
05
06
07
Dividend return
Capital return
Cumulative Return %
08
09
10
11
12
13
14
140
120
100
80
60
40
Source: MSCI, Invesco Perpetual, as at 31 December 2014.
02 Global Equity Investing: Investing for dividends and dividend growth
March 2015
A low interest-rate world and the role of dividends
Interest rates in many parts of the global economy are at either ‘emergency’ settings or
are low relative to any measure of near-term or long-term history. If the current debtdeleveraging cycle continues, which we anticipate it will, and lower growth is the outcome
for many global economies, then interest rates will potentially stay low for longer.
Figure 3 shows the current low and negative real interest rates in both the UK and
US markets respectively. In this scenario, investors exposed to low interest rates and
inflation are at risk of seeing their real wealth eroded.
Figure 4 illustrates the long-term relationship between dividends and inflation. Inflation
as we know it today was largely non-existent until the 1950s. Since then we have seen
persistent rising inflation. From a company investment perspective, inflation will lead
to rising nominal (if not real) earnings. If a company maintains a broadly even dividend
pay-out policy, then dividends should rise broadly in line with inflation. The evidence
over the last 110 years supports that notion, with nominal dividends rising in line with
inflation. Whilst the precise outlook for inflation is not clear, dividend yield has proved
an effective strategy to hedge against inflation.
US real interest rate
UK real interest rate
Figure 3
US and UK real interest rates since 1999
US and UK cash rate less inflation
USUK
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
4
6
4
2
2
0
0
-2
-2
-4
-4
-6
Source: Bloomberg, Invesco Perpetual, as at 31 December 2014.
Figure 4
Long-term inflation and dividend growth
Nominal dividends
US inflation
Dividends hedge against inflation
US nominal dividends against inflation since 1900
Nominal dividends (US$)
00
10
20
US inflation index
30
40
50
60
70
80
90
00
35
30
25
10
250
200
20
150
15
100
10
5
0
Source: Shiller, R, calculated by Invesco Perpetual, as at 4 October 2014.
03 Global Equity Investing: Investing for dividends and dividend growth
March 2015
50
0
Dividends and deflation
Today, inflationary pressures vary
globally. For investors, deflation can be a
significant threat. The risk to dividends in
a deflationary period is the risk of falling
earnings and the impact on dividends
thereafter. As figure 5 shows, companies
that can maintain their dividends
in disinflationary periods become
increasingly valuable as the real value
of their future dividend rises.
Figure 6 illustrates the point by taking 30 of world’s most recognised global companies, the
constituents of the Dow Jones Industrial Average. If you take those companies’ dividend
yields and subtract a proxy for their current corporate debt yield, you see that in most cases
the companies’ dividend yields are above their equivalent corporate bond yield.
Figure 5
The real value of dividends in periods of deflation
Outcome for investors:
Dividend change in
deflationary environment
Focusing therefore on dividend
sustainability, thorough testing of the
sustainability of cash flow is an important
component of dividend investing for
inflationary and deflationary environments.
Rising dividends, falling bond yields
Today, we see that many companies’ dividend yields are higher than their
corresponding bond yields. Where a company is distressed this makes sense, however,
where a company is a global multi-national with a diversified revenue base, with ample
capacity to pay and even grow its dividend, then we believe that this is anomalous.
Increase in real value of
dividend = Rise in dividend +
deflation effect
Dividend
rise
Increase in real value of
dividend = Deflation effect
Dividend
cut
Time
Decrease in real value of
dividend = Fall in dividend +
deflation effect
Source: Invesco Perpetual, as at 6 March 2015. For illustrative purposes only.
Dividend yield minus
company cost of debt
American Express Co
AT&T Inc
Boeing Co
Caterpillar Inc
Chevron Corp
Cisco Systems Inc
Coca-Cola Co
EI du Pont de Nemours & Co
Exxon Mobil Corp
General Electric Co
Goldman Sachs Group Inc
Home Depot Inc
Intel Corp
International Business Machines Corp
Johnson & Johnson
JPMorgan Chase & Co
McDonald's Corp
Merck & Co Inc
Microsoft Corp
NIKE Inc
Pfizer Inc
Procter & Gamble Co
Travelers Cos Inc
UnitedHealth Group Inc
United Technologies Corp
Visa Inc
Verizon Communications Inc
Wal-Mart Stores Inc
Walt Disney Co
3M Co
Figure 6
Dow Jones industrial average universe
– Dividend yield versus cost of debt
4
3
2
1
0
-1
Source: Bloomberg, as at 31 December 2014.
04 Global Equity Investing: Investing for dividends and dividend growth
March 2015
Our approach to equity income investing
As advocates of equity income investing, we believe that the approach taken is very
important. Investing into stocks with high dividend yields alone can be an unwise strategy.
Dividends are cash payments and as such the approach that we believe has the potential to
generate the highest long-term return is to focus on free-cash flow generation - the source
of the sustainable dividend.
There is evidence to support a cash-flow approach from Empirical Research Partners (see
figure 7). Looking back at the US market to 1965 we can observe that cash-flow yield (free
cash flow per share/share price) outperforms dividend yield in most markets. Focusing on
cash-flow yield and a company’s deployment of that cash flow is critical as that cash pays
the dividend, pays for dividend growth and allows a company to reinvest for growth.
Recessions
Figure 7
Large capitalisation stocks. Monthly return differential between
the best quintiles of free cash flow and dividend yield*
From 1964 to 1 March 2015
65
69
73
77
81
85
89
93
97
01
05
09
%
13
3.0
2.5
2.0
1.5
1.0
0.5
0.0
(0.5)
(1.0)
(1.5)
Source: National Bureau of Economic Research, Empirical Research Partners Analysis
* Equally-weighted data smoothed on a trailing twelve-month basis.
Conclusion
The dividend characteristics of companies are an important determinant of
performance. The practical evidence suggests that dividends are a signalling tool of
management confidence and that rising dividends equate to higher earnings growth
and performance in general. As investors, we believe we should differentiate between
sustainable and unsustainable dividends, and examining corporate cash flow is a means
by which this can be approached.
Bibliography
Aharony, J., & Swary, I. (1980, March).
Quarterly Dividend and Earnings
Announcements and Stockholders’
Returns: An Empirical Analysis. The
Journal of Finance, XXXV(1), 1-11.
Miller, M. H., & Modigliani, F. (1985,
September). Dividend Policy Under
Asymmetric Information. Journal of
Finance, 1031-51.
Spence, M. (1973, August). Job
Market Signalling. Quarterly Journal
of economics, 355-79.
05 Global Equity Investing: Investing for dividends and dividend growth
March 2015
Contact us
Important information
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This document is for Professional Clients and is not for consumer use.
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Telephone calls may be recorded.
The value of investments and any income will fluctuate (this may partly be the result of
exchange rate fluctuations) and investors may not get back the full amount invested.
Past performance is not a guide to future returns.
Where Nick Mustoe and the Global Equity Income Group have expressed opinions, they
are based on current market conditions and are subject to change without notice. These
opinions may differ from those of other Invesco Perpetual investment professionals.
Where securities are mentioned in this document they do not necessarily represent a
specific portfolio holding and do not constitute a recommendation to purchase, hold or sell.
Société Générale, the Global Income Investor, January 2011.
20 year Annualised Return to 31 December 2014, MSCI World Index. Total Return.
3
Data is for US Equity Market. No dividend per share data exists pre-1999 for MSCI World.
1
2
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Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK
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