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By Douw Steenkamp, 13 August 2013
We believe yes, they are, because there’s much more to the investment case for choosing dividends to meet your income needs than just comparing the dividend yield with prevailing bond yields. In addition to the attractive yields they offer, dividend-yielding investments also offer investors a yield that grows at a rate in excess of inflation over time and, as an equity investment, there’s the potential for capital growth too.
In contrast, the coupon paid out by a bond is set when it is issued and doesn’t change and, while the capital value of bond investments does change, sometimes dramatically, we believe the medium- to long-term risks are currently skewed towards capital losses given that bond yields are near all-time historic lows.
There’s no doubt high dividend yielding funds have become ‘flavour of the month’ in an environment of historically low yields on cash and debt products – and a number of asset managers have launched global products aiming to maximise dividend yields.
The fact that the average dividend yield of most developed country equity markets has exceeded the yield to maturity of their respective bond markets for the first time since the 1950’s has added to their popularity (see above graph).
Whatever happens to relative yields, however, we believe, and my experience has taught me, that the returns delivered by investment portfolios that specifically aim to maximise dividend yields are, in the long-term, very attractive to investors requiring a steady periodic income coupled with inflation-beating capital appreciation and a palatable level of volatility.
The fact that the underlying dividend stream generally grows from one year to the next, in line with the growth of the investee companies, means that the quantum of income paid to investors also grows from year to year. For example, assuming a dividend-yielding fund can generate an annual yield of 4% by investing in companies that are growing their dividends by 10% a year, in the fifth year an investor in the fund would receive income equating to a yield of 5.9% on the original investment.
Also, dividend yielding funds have proved to be defensive through both bull and bear markets and thus could be a valuable addition to a diversified offshore portfolio (see graph below).
Last year we launched the SIM Global Equity Income fund and, in the current environment, we have been able to construct a diversified portfolio that promises to generate a yield, net of dividend withholding taxes, which are payable by the Fund, of 4.5% over the next 12 months. This compares very favourably to the estimated equivalent yield of 3.6% for the benchmark and the less than 1% on offer for a 12-month cash deposit in the US. Much of the difference in performance relative to the MSCI High Dividend Yield Index benchmark is explained by our greater exposure to European- and UK-domiciled companies, which liberates us from the 30% dividend withholding tax levied in the US.
In addition, the portfolio has the all the characteristics of a value fund: a lower price-to-earnings ratio than the benchmark (13.0x vs. 14.7x as at end-June 2013), while the dividend stream is expected to grow by about 8% in US dollars during the next year.
The SIM Global Equity Income Fund’s objective is to deliver to our investors a hard currency income yield, derived from the dividends received from our underlying share investments, equal to or greater than the yield of the MSCI World High Dividend Yield Index. This Index consists of a subset of shares in the MSCI World Index with the highest dividend yields and its yield was chosen as our benchmark because it represents a challenging target that automatically adjusts as the yields available in the global equity market change, with the index rebalanced on a quarterly basis.
It is important to understand that our primary objective is to achieve the yield and not to try and beat the return of the Index. For many investors this is initially a difficult proposition to accept because it is the norm for equity funds always to strive to achieve or beat some total return measure. The problem is that, in trying to achieve such an objective, the fund manager invariably tends to concentrate his effort on trying to maximise the fund’s capital return and pays little or no regard to the dividend yield.
When considering how the Fund is performing relative to the benchmark MSCI High Dividend Index, it is also worth considering that the Index doesn’t take dividend withholding taxes into account, whereas we do. As a result, the benchmark is heavily weighted towards US dividend-paying companies and we tend to have less exposure to US stocks because of the hefty 30% dividend withholding tax paid in that jurisdiction. We prefer to find that exposure elsewhere where dividend yields net of tax are more compelling.
The speculation regarding the timing of an end to quantitative easing and the first interest rate hike in the US did have an impact on dividend-yielding funds during the second quarter of the year, heralding a move out of high yielding equities. This weighed on the performance of the MSCI World High Dividend Yield index (-1.3%) and the Fund (-2.0%).
My experience, however, has taught me that it is nigh impossible to serve two masters equally and that by focusing your attention on achieving a growing and sustainable yield, a very acceptable level of capital appreciation invariably follows (see graph below).
The reason for this is threefold: first, in selecting the shares for our portfolio, we refer not only to the historic and expected dividend yield of companies but also concentrate on assessing the likelihood of the company maintaining and growing its dividend payments.
Key to such an assessment is the company’s dividend history, its dividend policy, the management’s commitment to maintaining dividend payments, the business’ cash generation ability and the health of its balance sheet. The companies that survive this screening are not only expected to maintain their dividend payments for the next few years but to increase them.
Second, a seminal study by Arnott and Asness published in 2003 showed that companies that consistently return a significant portion of their profits to shareholders by way of dividends achieve better earnings growth in future years than companies that do not1. This statement normally elicits howls of protest because the entrenched conventional wisdom is that companies who retain and reinvest their earnings generally outgrow those that pay generous dividends. This was, in fact, what the researchers set out to prove – and were as surprised as everyone else when their study proved the exact opposite!
The most common explanations for this seemingly counterintuitive outcome were found to be the cost impact of unproductive empire building, sub-economic investments and overpriced acquisitions by managements with too much cash at their disposal. It was also found that the maintenance of the dividend payment by companies that are experiencing a temporary earnings setback is often a signal from management that things are set to get better.
Third, dividend yield is a reliable indicator of value. By using this metric as your guide to construct a portfolio, you will – per definition – end up with a ‘value’ portfolio and, as has been shown over and over, the value style inevitably beats the market in the longer-term.
For all these reasons, we believe a high dividend-yielding investment fund with global exposure is an exciting alternative for patient investors and deserves a permanent place in your investment portfolio.