Dividend and conquer

Equity income as an investment style has struggled since 2014. Income investing has lost fans as structural growth assets have dominated market returns and dividend have been cut in response to the pandemic. However, we believe the economy’s rapid shift from recovery to expansionary phase means it’s now time to revisit the investment case.

Dividends: a good source of capital growth

Some investors have a one dimensional view of dividends as a one-off source of income. We believe this overlooks the value creation that can be gained through reinvesting dividends, which allows an investor to realise more value from the initial dividend as it compounds over time.

Looking at the income strategies that we manage, we noted that around 55% of the unit holders/investors had chosen to reinvest the dividends through the accumulation share class vs receive dividends as income

Figure 1 demonstrates how, over time, reinvested dividends compound and can become a significant component of total shareholder return. We have modelled what would have happened if we had reinvested the dividends, received each year, back into the component companies of the Euro Stoxx 600 index.

We have assumed all of the dividends are received and then reinvested at year end. The light blue area shows the headline dividends, the green component shows the additional return that would have been earned by reinvesting these dividends.

When we include both of these dividend components, even at index level the dividends become the main source of return over time. More than the capital gains we get based on the index earnings growth and the change in Price Earnings (PE) multiple (dark blue component).

We believe this analysis shows the importance of dividends over time. However, the full power of income investing is unlocked when we can buy the dividend paying companies below their fair value.

When we find a robust dividend paying equity trading below its intrinsic value, we stand to benefit in three ways. We earn the high dividend yield, we can reinvest this high yield and we stand to benefit from the eventual re-rating of the underlying stock.

Right now, we have identified many robust, dividend paying companies trading on what we believe to be unfairly high dividend yields. In our view, this provides another compelling reason to look at this asset class.

Dividend paying stocks underappreciated by the market

Dividend investing is out of favour. We can see this from the underperformance of income stocks against other equity styles over recent years. 

We have identified two key reasons for this underperformance:

1. Short duration vs long duration equities
   
   We believe the lack of perceived nominal growth has created valuation distortions in the equity market. This has led to a large difference between the valuations of short duration equities (that tend to outperform in a rising interest rate environment) and long duration equities. To maintain an above market yield, income mandates have been forced into cyclicals and out of the low dividend yielding structural growth stocks. This has then weighed on performance in recent years.
   
   
2. 2020 was a distinctive year of dividend cuts
   
   Last year saw many dividend cuts. The unique situation we found ourselves in meant companies were forced to cut for non-financial reasons, such as, political pressure, social pressure or it was even dictated by regulators. We saw cuts from what were perceived to be dependable dividend payers. This broke the contract with investors and hurt the asset class.

A brighter future for income investing

We think going forward some of these headwinds will begin to abate.

The unique nature of the current situation means we are already moving from the recovery to the expansionary phase of this economic cycle. We believe that this will translate to rapid earnings growth for more cyclical names, which could outgrow the non-dividend paying structural growth names.

Furthermore, as a lot of the dividend cuts were not financially motivated but rather based on moral suasion, many of the companies in question ended 2020 with healthy balance sheets. This is very different to the previous cycles. Management teams could  fully reinstate dividends this year or even compensate shareholders for the missed 2020 dividends. 

Rising concerns of inflation are also likely to help the equity income asset class. Unlike most fixed income coupons, dividends can offer an income stream that is broadly protected against inflation. 

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