When you own shares, you own a slice of a real, cash-generating business. If that business is growing its profits, then over time it will be able to increase its dividends, and the capital value of that business will also grow. If the business has a big growth opportunity, and a differentiated way of seizing it, then over time this growth in profits, dividends and capital can significantly outpace inflation.
In our view, the ability to deliver both income and growth is the key reason that many income-seeking investors would want to own equities. They will often have some investments which offer high levels of income today, but where this income is not going to keep pace with inflation over time. As time passes, the capital value of these investments is also often eroded. Bonds are a good example. There may be valid reasons for owning them – but if an investor’s portfolio income is going to keep pace with inflation over the long term, then they need to balance these holdings with income-generating assets that are also capable of delivering growth.
UK investors have historically understood this, and have had large allocations in income-generating equities. However, today, these investments are mostly made in the domestic stock market.
We find this odd, for two reasons. Firstly, the UK market has become profoundly skewed over recent years, and its income stream is now dominated by some unwieldy businesses, which we struggle to see growing their dividends (or even sustaining them, in some cases). Secondly, and perhaps more importantly, we are now finding so many exciting dividend payers listed in other countries, with interesting business models and dynamic management teams. We think many of these can offer investors both a dependable income stream and long-term growth.
So, what should an income investor make of the UK equity market today?
On the one hand, the FTSE All-Share currently offers an apparently enticing yield of 3.6% p.a. – at a time when returns on cash are exceptionally low.
On the other, the income stream of the UK market is now profoundly skewed, in a way that is likely to compromise an investor’s long-term interests. Our estimate is that over half of the dividends paid by FTSE All-Share companies in 2017 will be paid by just 10 companies – with just three companies (Royal Dutch Shell, HSBC and BP) representing 30% of the total.
This skew towards a handful of businesses raises a number of problems for those who invest in the index for both income and growth.
Firstly, these investors would probably not choose to have an income stream that was so exposed to the dividend decisions of such a small number of company boards – especially when two of the top three businesses operate in the notoriously volatile oil and gas sector. The overall dividend stream is a much riskier one than most investors would expect.
This is a particular problem because several of the businesses that deliver the bulk of the income are currently distributing too much of their profits as dividends. This problem of over-distribution extends beyond those three largest companies; in fact only one of the 10 largest dividend distributors is retaining more than half of its earnings. Retaining profits and cash is crucial because it is retained profits that businesses either reinvest to support future growth, or use to build up a buffer for tougher times.
And yet for the 10 biggest UK payers, the cash is flying out the door:
Dividend payout ratios for the 10 largest income contributors of the FTSE All-Share
Source: Baillie Gifford & Co, Bloomberg, IBES and relevant underlying index provider(s). Totals may not sum due to rounding. Data to 30 September 2017.
Indeed, today, distributions at Royal Dutch Shell, HSBC and BP are so excessive that they have resorted to scrip dividends. Each year they are issuing large numbers of shares to investors in place of dividends, because they just don’t have the cash to fund their dividend commitments. Scrip dividends are often a sign that a company’s dividend policy is not fit-for-purpose. The companies are admitting that they have got the balance between paying out and reinvestment badly wrong. This increases the risk of dividend cuts.
Even if these businesses were not currently over-distributing dividends, we would not invest our clients’ capital in most of them. The reason for this is our philosophical belief about what it is that our clients are looking for when they invest in equities for income.
As noted earlier, what makes equities unique is the exposure they offer to growing businesses, which in turn allows them to deliver real growth in dividends, and also capital growth.
If a business is going to deliver this real growth, then it needs to have three things:
In our view, only an equity portfolio filled with businesses that offer all three is well-suited to meet the needs of a long-term income investor.
However, these businesses are rare. It is, therefore, helpful to have the broadest possible range of companies to choose from, so that we can be both very selective in what we own, and well-diversified.
By looking globally, we have a universe of over 2,300 investible, established, dividend-paying stocks available to us. This is over eight times the number we would be able to choose from if we were restricted solely to the UK market.1
1. The number of dividend-paying stocks with a market capitalisation of >£1bn in the Global Universe; the equivalent number in the UK is 263. An alternative answer to this challenge is to include small-cap companies – but the risk profile of these businesses is often higher, and liquidity is lower. We think that going global offers a less risky way of broadening the opportunity set.
But it’s not just the far larger number of dividend-paying businesses that excites us – it’s also the impressive quality of those that we uncover in other markets around the world. Some of these businesses may not be well-known to UK investors. For example AVI, the South African biscuit and tea company, or Anta Sports, the leading Chinese sportswear brand.
These businesses are typical of the types of companies we invest in. Both have large volume growth opportunities ahead of them, as consumers continue to demand more of their products. But they also operate in industries where this growth doesn’t require substantial investments in fixed assets. Growth here can go hand-in-hand with dividends – and in both cases we think the boards are strongly committed to these dividends.
Having broader horizons also allows us as long-term income portfolio managers to take positions in businesses for which rapid technological change is an opportunity, rather than an existential threat.
For instance, companies such as Analog Devices are designing many of the semiconductors that will enable the electrification of the car fleet over the coming decades, as well as those that are helping automate many industrial processes. We believe Analog is set to see rapid demand growth over the coming years, and because it’s primarily a design company, it won’t need to put huge amounts of capital at risk in order to take advantage of this positive backdrop. Its business model generates a lot of cash, and because it is not over-distributing we think its dividends should be resilient, even in tougher times.
Companies like these have an opportunity to grow their profits and cash flows rapidly over the next five to 10 years and more. If they seize that opportunity, then not only will they be able to pay out significantly higher dividends, but the capital value of these businesses is likely to grow substantially too.
They offer exactly the balance of income and growth that we think investors are seeking from their equities.
The Global Income Growth team invest in businesses listed in 18 countries around the world. Here are just a few examples:
There’s an additional benefit of searching globally for income and growth. Not only are we able to find many resilient, growing businesses listed in other markets, but it allows us to construct a much more diversified, dependable income stream than we would be able to if we were constrained to the UK market alone.
No industry currently represents more than 6% of our portfolio’s income stream, for example, and we derive much of the income from industries where there is a lot of growth available, but which just aren’t well-represented in the UK market.
Our extensive range of opportunities allows us to find 60-70 stocks which meet our criteria, and enables us to diversify stock-specific risks to the income stream. We impose a 5% limit on the contribution that any one stock can make to the portfolio’s income, and today the portfolio’s top 10 income contributors account for under 30% of its income.
Source: Baillie Gifford & Co, Bloomberg, IBES and relevant underlying index provider(s). Totals may not sum due to rounding. Data to 30 September 2017.
Investors who are considering going global for income often have two concerns.
One is whether a global equity income portfolio will receive more of its income from currencies other than sterling, when compared to the UK market. If sterling appreciates substantially, the value of these foreign dividends may fall. The relative risk can be over-stated, though. Six of the 10 largest dividend payers in the UK market set their dividends in non-sterling currencies, and these giants account for over 40% of the UK market’s dividend stream – so even passive income investors in the UK market are taking on some currency risk.
As managers, we believe that the best way to manage the portfolio’s currency risk is to focus on finding companies with strong underlying growth. If a business is capable of growing its real earnings and dividends by a double-digit percentage each year, then the power of this strong growth will dwarf any moves in currencies in the long run.
We also believe that being exposed to a range of currencies is a function of a portfolio that is exposed to a wide range of end-markets and demand drivers. The diversity of markets that we are exposed to is very helpful for building a resilient income stream. We do find some great global businesses in the UK, but have substantially more of our clients’ capital invested in companies based in emerging markets, Asia, and other countries where we believe the growth opportunities are often superior.
The second issue is that going global may mean giving up some near-term yield. For instance, our Global Income Growth portfolio has a yield of just under 3% p.a., while the UK market yields around 3.6% p.a.. However, as we’ve tried to demonstrate in this paper, we believe that chasing this high near-term yield is likely to come at a high cost.
The UK market’s high yield is dominated by a handful of mega-caps, which are currently over-distributing. The yield is therefore not a dependable one, which is a key reason why we believe an approach that focuses on dependable dividends and growth is likely to deliver more income over the long term. It should deliver much more attractive long-term capital growth too.
We mentioned earlier that exposure to growth is what makes equities a unique income-generating asset class.
However, finding companies capable of delivering both a dependable income stream and significant growth over the long term is hard. It requires stock-picking, and this stock-picking benefits from having the broadest possible opportunity set. The benefits of looking globally are increasingly clear – and as the income from the UK market becomes more skewed, the dangers of anchoring on a narrow UK market are becoming starker.
This sounds like an obvious argument. However, today only 21% of UK investors’ allocations to equity income are in global equity income funds.2 This makes little sense to us – especially given the exciting opportunities for income and growth that we see available to us in other markets.
2. Investment Association, August 2017: £63.4bn in UK Equity Income funds, vs £17.2bn in Global Equity Income funds.
All data to 30 September 2017 unless otherwise stated and source Baillie Gifford & Co and relevant underlying index providers.
*Expected yield for the Global Income Growth Fund based on Baillie Gifford’s current forecast for the portfolio, at 30 September 2017. Expected yield for SAINTS based on annualising last quarterly dividend, vs the closing share price on 30 September 2017.
**Relative to FTSE All World Index. Source: Baillie Gifford & Co and relevant underlying index provider(s). For SAINTS this relates to the global equity income portfolio only. SAINTS also makes investments in property and fixed interest securities.
The views expressed in this article are those of Toby Ross and James Dow and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved on the stated date and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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Any stock examples and images used in this article are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style.
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Annual past performance to 30 September each year (net %)
|Baillie Gifford Global Income Growth||7.0||2.6||29.5||13.0||10.0|
|FTSE All-World Index||11.8||0.6||31.3||15.5||13.4|
|FTSE All-Share Index||6.1||-2.3||16.8||11.9||5.9|
Source: Baillie Gifford & Co and FTSE. Figures in GBP.
Changes in the investment strategies, contributions or withdrawals may materially alter the performance and results of the portfolio.
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