With yields on traditional fixed income at historic lows, investors are finding it increasingly difficult to generate meaningful income. Richard Turnill and Stuart Reeve, portfolio managers, BlackRock Global Dividend Income Fund, believe a high-quality portfolio of global dividend-paying stocks offers the benefits of international diversification, growing income and less volatility than the broader stock market.
Why dividends? Dividend yield and dividend growth have accounted for approximately 90% of long-term stock returns, far outstripping the contribution of valuation moves.
Why global? International equities historically have yielded more than US equities, with the spread currently at more than 150 basis points.
Why now? During periods of low growth, very little return comes from multiple expansion; it comes almost exclusively from dividend yield and dividend growth.
What are the challenges investors face today?
There are a number of menaces out there today, but we would boil it down to three key questions on investors’ minds: 1) How do I invest in a slow-growth environment; 2) How do I make money in an environment of low interest rates; and 3) How do I invest in a highly volatile market?
Let’s tackle each. How do you invest in a slow-growth environment?
We’ll start with the facts and then try to put it in perspective.
Fact: The average real gross domestic product (GDP) growth rate of major countries around the world has been falling for several decades. We expect this situation to persist into the foreseeable future, and there are several reasons for that. First, the large-scale deleveraging occurring in the Western world will persist for at least the short-term; second, corporate profit margins are at peak levels; and third, the policy response to a China slowdown has been modest so far. All of these uncertainties will continue to weigh on global economies.
That said, not all countries are experiencing the same levels of growth. The much slower growth seen in the highly indebted developed markets is countered by higher growth in emerging markets. For that reason, we believe investors should seek growing income through dividends and incorporate emerging markets exposure into their investments.
Now, emerging markets exposure does not require direct investment in far-off, little-known lands. The majority of our emerging markets exposure actually comes through owning internationally diversified, global businesses. The fact that emerging markets lagged behind developed markets during the first quarter equity upswing provides the added bonus that these markets now display relatively attractive valuations.
Bottom line: The hunt for continued growth is crucial because, over the long-term, we believe the majority of an equity investor’s returns will come from the powerful combination of dividend growth and yield.
Why is it not enough to focus on current yield?
When building a portfolio of dividend-paying companies, many investors make the mistake of focusing exclusively on the stocks with the highest yields. However, a very high yield often signifies that a company is distressed and may not actually be able to pay its dividend going forward. While an above-average yield is an important component of total return, we believe dividend growth—a company’s ability to consistently raise its dividends—is even more powerful over the long term, through the compounding of growth on growth.
Let’s discuss that second big question: How do investors make money amid low rates?
Again we have to look at the facts. Developed market interest rates have been held at record lows for more than three years now. What does this mean for investors? Traditional sources of stable yield, such as government bonds and cash instruments, are delivering negative returns after factoring in inflation. Government bonds used to be thought of as risk-free return assets, but perhaps this title should be changed to “return-free risk.”
Meanwhile, stock yields are higher than government bond yields for the first time in a generation. This is quite exciting. We view stocks as claims on future cash flows, similar to the claims on coupons offered by fixed income. It is now more expensive to buy these future cash flows through bonds than it is through stocks! Another reason to be wary of fixed income today is that, because bond coupons are fixed, the purchasing power of a typical fixed income investment will be eroded by inflation over time. Companies that can exercise pricing power are able to pass cost inflation onto the end consumer by increasing prices, which ultimately means that dividend payments can increase.
So global dividend investing would be appropriate for a retirement portfolio?
Absolutely. Retirees are exactly the type of investors who need to keep ahead of inflation so that their nest eggs do not expire before they do. Traditional income sources (i.e., cash and bonds) cannot offer that kind of income growth. This point has become increasingly important as the average time in retirement has expanded to well beyond 20 years.
What about the issue of increased volatility?
The past few years have delivered some of the worst market volatility in history. Worryingly, data suggests the period of low volatility we had all grown used to, known as the Great Moderation, could be the anomaly. The most recent period of heightened volatility may actually be more the ‘norm’. In practice, this means we should all expect the business cycles to be shorter, and sharper, going forward. Combined with the ongoing political and economic uncertainty emanating from Europe, investors need to be prepared, and their portfolios positioned, for continued volatility. The good news is that, in our experience, it is possible to invest in such a way that produces an equity portfolio with approximately one-third less volatility than broader equities. In our search for dividend growth and yield, we aim to invest only in the highest-quality companies that benefit from globally diversified revenue streams.
What do you mean by globally diversified revenue streams?
For us, it means gaining exposure to ‘transnational’ companies—that is, global businesses whose headquarters location has little to do with where they generate revenue. Transnationals do not derive their revenue from a single market, but have operations and senior executives spread throughout the world. Transnationals also have the ability to access emerging markets and other higher-growth areas using local expertise.
We believe these companies have long-term potential thanks to their global revenue diversification, and we’ve been able to find them at attractive valuations. The names of many of these companies might surprise some investors. McDonald’s, an iconic American brand, is just one example. Investors need only check the company’s website to find that just 30% of its exposure is in the US; 40% of revenue is generated in Europe. Another example is UPS. While a US-listed company, “Big Brown” actually ships parcels in 200 countries daily. That’s quite a global reach. We like to see this kind of diversity in a company’s revenue stream.
In other words, you like high quality for low volatility?
That’s exactly right. We invest in 50 to 70 of what we believe to be the highest-quality stocks in the world. High-quality companies historically have provided lower levels of volatility, weathering adverse market conditions better than their low-quality counterparts.
How do you narrow the field to target the highest-quality companies?
We invest worldwide in companies that operate in industries with high barriers to entry as well as those that benefit from competitive advantages relative to peers. These companies tend to be much more cash generative and, in our view, are better placed to navigate challenging market environments. We also focus on companies with solid balance sheets—low financial leverage, in particular, is a key factor we look for. These types of companies also tend to be better at navigating market volatility.
Finally, and importantly, we want to select companies that are committed to returning cash to investors, via dividends, as well as increasing shareholder value over the long term by growing that cash flow. While there is no guarantee that dividend-paying stocks will continue to pay dividends in the future, we believe that quality, with a focus on companies that can grow earnings and free cash flow, is a key aspect of successful dividend investing during low-growth environments, which is exactly where we are now.
In a nutshell, high-quality companies typically have three very important attributes: 1) Consistent cash-flow generation throughout the entire economic cycle; 2) Healthy balance sheets with low levels of debt; and 3) A history of growing dividends, which demonstrates a commitment to shareholders and sends an important signal about management’s confidence in future cash returns.
Some readers may be thinking equity investing is about taking more risk for more return.
Conventional finance theory does state that the only way to earn a greater return is through accepting greater risk. However, our research actually turns this relationship on its head because, over the long term, we’ve found the lower-volatility stocks (higher-quality companies) have produced better risk-adjusted returns than higher-volatility stocks (lower-quality companies). In fact, this finding is gaining wider acceptance among academics and industry peers, with the consensus explanation centering around investor psychology and limits to arbitrage.
A further benefit to investing in high-quality companies is the resulting minimisation of the volatility drag—in other words, losing less money on the downside makes it easier to grow wealth over the long term.
Has the popularity of dividend investing made it less of a “find” today?
That may be true for some of the highest-yielding stocks. Many of these have been overbought and are quite expensive now. However, we’re not focused on the highest dividends. We’re looking for quality companies with a proven ability to maintain and grow their dividends.
Notably, the valuation of the Global Dividend Income Fund portfolio (in P/E terms) has only changed slightly since 2010, whereas the broader market has fluctuated within a much wider range. It is also interesting to note that the general category of equity income investing still makes up a very small proportion of the overall asset management industry.
Why is it important that dividend investors diversify globally?
Although investing globally historically involves special risks, it also has offered the benefits of enhanced diversification and higher yields when compared with a strictly US-centric portfolio. While diversification does not ensure a profit, it has been shown to smooth the ride.
Following a tradition of returning more capital to shareholders, foreign companies’ dividend yields have consistently hovered approximately 100 basis points above those of their US counterparts.
Anecdotally, average US stocks are trading at a roughly 30%-40% premium to UK, German and French stocks. This allows us to invest in high-quality, global businesses at relatively attractive prices. Consider Sanofi, which comes at what we believe to be an attractive price just because it happens to be listed in France. The kicker is that Sanofi only generates about 30% of its revenue from Europe. Compare that to our earlier example of McDonald’s, which generates 40% of revenue from Europe.
How should investors incorporate global dividend stocks into their investment portfolio?
Although the dividend-paying companies in which we invest are equities in simple terms, we believe the characteristics we discussed make these stocks behave very differently from normal equities. For that reason, we believe they should be thought of as a separate asset class. Ideally, global dividend stocks should represent a core component of a portfolio, as they have shown to be a successful long-term investment. The low-volatility nature of these stocks, in our view, allows investors to increase their absolute allocation to equities without appreciably increasing their exposure to equity risk.
Richard Turnill, Managing Director and Portfolio Manager, is head of BlackRock’s Global Equity team and lead portfolio manager for Global Core portfolios. Mr. Turnill’s service with the firm dates back to 1996, including his years with Merrill Lynch Investment Managers (MLIM), which merged with BlackRock in 2006.
Stuart Reeve, Managing Director and Portfolio Manager, is a member of the Global Equity team and lead portfolio manager for all retail and institutional Global Dividend Income portfolios. He is also Director of Research for the Global Equity team. Mr. Reeve’s service with the firm dates back to 2005, including his years with MLIM.
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