Equity investors hunting for yield need to consider their chosen destinations carefully. On the face of it, payouts, fuelled by rising earnings, look robust, but scratch beneath the surface and it becomes clear that dividend cover is stretched thin in some parts of the world. A more nuanced approach is vital, so best to keep the following in mind.
Don’t just jump at attractive dividends
When rates are low, as they are today, dividends are highly prized by investors, prompting some companies to pay them regardless of their earnings. This can lead to a significant decline in dividend cover. We saw this earlier in the year in the UK, when (according to Capita’s Q2 2017 Dividend Monitor) coverage dropped to just 0.8x – the lowest level since 2009.
Income is expensive
Investors are paying a lot for income by historic standards, with the MSCI World’s dividend yield at its lowest in 10 years. The growth in global dividend payouts may look impressive, but beneath the surface is a problem of peak dividend payouts and peak share prices. Overpaying for income is a real danger.
Beware dividend cuts
When payouts and share prices are at a peak, inevitably there is a greater risk of dividend cuts. After all, a high yield isn’t always a good yield – some companies offer high dividends because they involve an element of distress.
At Lyxor, we have no interest in such companies. Instead, we focus on less fashionable, more mature companies that can pay – and keep on paying – a high dividend. They still represent solid, low-risk investments.
We use nine key tests to analyse each prospective investment’s balance sheet strength and cash flow in order to determine whether it is of high enough quality for us to invest. From there, we look at whether we can buy them with a sufficiently high dividend yield.
The type of business our approach leads us to shifts over time. Right now, for example, it’s difficult to pick up consumer staples businesses with a high enough yield. So, our global portfolio is currently weighted towards telecoms, utilities, industrials, and pharmaceuticals. This positioning ebbs and flows with the markets – as stocks get more expensive, the strategy naturally moves towards more defensive, less popular areas.
The following are key considerations, amongst others:
Ensuring an attractive yield
A stock needs to pay a 4% dividend for us to invest, and if this drops below 3.5%, we sell it. The only exception is for our Japanese index, which has a starting yield of around 2.5%.
A selective approach
In our global portfolio, we tend to have significant, enduring exposures to countries like Canada and Australia, which have tax-friendly, well-established dividend regimes. We also favour countries where the right kinds of businesses have a firm foothold, such as the UK (pharmaceuticals) and Switzerland (consumer goods producers).
In the US, the S&P 500’s yield habitually hovers around 2%, so finding a higher yield means narrowing your search. We can find plenty of high quality businesses, but their tendency to substitute dividend payments with share buybacks means our process cannot identify enough good companies with high enough dividend yields to justify a higher weighting in our global portfolio. Other strategies might have more leeway. For us, Europe and Asia are better hunting grounds.
The attraction of Europe
Continental Europe is a bountiful region for dividend investors because of the diversity of companies providing an attractive yield. Around a third of the global 4% dividend yield universe can be found in Europe, and about 30% of European stocks provide a yield of 4% or more.
All European equity sectors currently offer a dividend yield in excess of the 10-year bund yield. Six offer a yield greater than 4%, but we are currently focusing on traditional areas like utilities, telecoms, and consumer services. Overall, the ground is fertile enough for our European strategy to yield more than 4.5%.
The next dividend frontier? Asia
Asia is becoming much more attractive from a dividend perspective. Companies across the region have been steadily increasing their dividends for some time, and there’s much more scope here for dividend growth than, for example, in the UK. You also get more natural diversification – dividend payers come from across the industry spectrum, including technology.
Japan, for its part, has long been relatively uninspiring for dividend seekers, with low yields and high valuations. But corporate governance has improved and share prices have fallen, and Japan now has the best dividend cover and payout ratio in the world. We’re much more interested in Japan today than we used to be, and will soon launch a dividend ETF providing discrete exposure to Japan. It will adopt the same methodology as our global strategy and apply it to the Japanese market.
Unless otherwise noted, all opinions/data sourced from SG Cross Asset & Global Quantitative Research teams. Opinions expressed are as at 23 August 2017.
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