Why do we own Tencent in an income strategy?

It is indisputably a fair question.

Tencent has a yield of about 20 basis points, which is negligible in our desire to have a strategy that yields in excess of the market. Free cash flow from the company’s operations are prolific, but only about 10% is directed towards the dividend. It would be fair to assume that the dividend is not a priority. However, this example is useful in explaining how we think about managing a global equity income strategy and the type of companies we invest in.

Firstly, we think about income at a strategy level, not on an individual stock basis. Having a yield requirement at a stock level is restrictive. Within the MSCI World index, less than 30% of the companies have a yield greater than the market. Our potential universe is much bigger. Dividend yield also does little to inform us about dividend growth: which are the companies that will be paying dividends in the future? Despite the small dividend yield, Tencent has grown its dividend c27% pa over the last 5 years¹. There are several academic studies which look at the relationship between dividend growth and share price appreciation and the results are apparent, see Figure 1. We firmly believe it is identifying dividend growth that will drive share prices and ultimately our success.

If we take another example of a company that had consistently paid a dividend above market yield (for the last 9 years), but has failed to grow this dividend, then the share price performance is revealing. Swisscom would be perceived by many investors as a classic equity income investment; a defensive sector (telecom) with an attractive yield sustained over many years. However, if we compare it with Tencent (Figure 2), there is a significant opportunity cost of owning this type of business.

While we appreciate the discipline of companies that can grow dividends over time, we also recognise the role of income as a persistent part of an investors total return. Therefore, the bar for investments with low yield is high: the growth opportunity they offer must be significant and the characteristics they possess must be industry leading.

We believe that Tencent is a unique business, with characteristics that make it a compelling component of any strategy. Firstly, it acts as an operating system for the population of China that is entrenched in daily life: chatting with friends, ordering taxis, playing games, dining, listening to music etc. It is hard to disintermediate on so many levels. Secondly, its growth sources are diversified - from games to payments, from social interactions to cloud. Finally, the financial characteristics of the business are compelling: net cash balance sheet and importantly the ability to deploy capital at high returns. If a business has the opportunity to reinvest in its own business at high rates, this allows it to continue to grow free cash flow which in turn will allow the dividend to grow.

We seek to balance the income and growth opportunities in the strategy (both will be important drivers of return) and seek to deliver a yield that is in excess of the market. However, we do not want to impose an arbitrary yield constraint at a stock level: this diminishes our opportunity set and therefore our total return potential. Having an income mandate should not dissuade us from owning some wonderful companies that can invest in their own business at very attractive rates. We believe we are differentiated by having a combined income and growth mandate that allows us to focus on building a portfolio without bias.