Rising Dividends Remain Undervalued
The Global Income equity strategy is unconstrained by geography, sector or stock, and is committed to achieving the target yield based on the opening NAV at the beginning of each financial year of 4.5%, payable in equal quarterly dividends with any excess paid out at the end of the year. It may only invest in companies with an historic dividend yield of at least 2.5% based on the price at the date of purchase. There is a bar on using derivatives or options to achieve the target yield and it must invest in a company on its merits rather than rotational dividend stripping.
Since December 2012, the portfolio has increased 16.2% whilst the rise in the index was 14.6%. The month saw minor underperformance, with the portfolio falling 34 basis points more than the index. The causes are set out overleaf. Equity markets continue to behave like Dr. Doolittle's “pushmi-pullyu”. The global monetary base remains extremely loose (chart 2, Page 4) providing plenty of support for real asset prices, especially equities. Against this, private sector credit growth in the developed markets remains weak, and is contracting both in America and across much of the Eurozone. Credit growth to non- financial companies is waning with the exception of Japan which is finally recovering from years of moribund activity (chart 3, Page 4). In contrast, non-financial corporate leverage amongst many of the largest emerging markets is not only too high, but has continued to rise (chart 1, Page 4). Given the dependency of these countries on consumer demand from the developed countries which will remain subdued, they too will have to deleverage. In practice therefore, the private sector across most countries continues to reduce its borrowing, in effect a return to normality. It is against this background that central banks are looking to reduce their bond purchasing programmes, known as "tapering". Given that a mild recession would eventuate within months, this seems unlikely - or the amount of tapering will be fractional. Therefore central banks will continue to hold interest rates as close to zero as possible at the short-end and equity valuations will remain supported by these loose monetary conditions.
Dividend yields outside of America are all near or well above their long-term averages. Steep falls in emerging market indices have increased yields there significantly, from a 10-year average of 2.4% to 3.2%, thus providing more opportunities. Yields in the developed markets have also risen to the top quartile of their 20-year range; save for the spike during the 2008/2009 financial crisis, they have not been at current levels since 1992. The stand out is America, where domestic investors continue to buy the myth that dividends do not matter and that share buy backs add value. Hence the market yield there remains low at 2%, in turn one of several reasons for the portfolio's low weighting at 18% in North America vs. 52% for the index. Yet as measured by their quarterly value, the buyback craze is gradually waning. Thus here too there is a gradual return to normality with shareholders being paid a cash rent for their capital (i.e. dividends). Western European shareholders however have always demanded dividends which is one of several reasons for the fund's significant 28% weighting there, roughly twice that of the index.
Dividend yields are beginning to look anomalous. They have backed up in anticipation of rapid tapering but as Bedlam has long argued, this seems improbable as once having embarked on support programmes, governments will find them difficult to end as Japan found out in its "lost decade". Thus assuming that tapering is mild, those companies with sustainable and rising dividends should continue to be gradually re-rated, a trend already evident in sectors such as healthcare or mobile telcos, to which the fund has a high 28% weighting.
Other valuations also look anomalous. Cyclically adjusted PEs (CAPE, based on January 2006) show major indices – with the exception of America again– at least one standard deviation below their 10 year averages and often, bottom quartile. Simple prospective PERs are also at the lower end of their ranges: much of the data implies that valuations are reasonable. Moreover, the relatively low level of borrowing in developed markets implies that if interest rates rise faster than expected, the risk of companies being unable to maintain their dividends is relatively low. Moreover, equity yields are particularly anomalous when compared to those of bank deposits or government bonds. Thus there is a strong inference that dividend yields remain undervalued. No-one knows how to price decent companies yielding over 3% as central banks continuously pump in liquidity and suppress interest rates, because it has never happened before.
There are three obvious risks to equity markets; as discussed, that of central banks rapidly reducing their support operations is low. The slow motion car crash in China's financial sector is serious and probable; whilst some of the effects cannot be foreseen, others will include further downward pressure on commodity prices and the exporting of deflation. The final risk, as ever, remains earnings growth. Expectations have been too high and rolling 12 months EPS forecasts for the world index continue tobe reduced. The current consensus is a 6.3% increase (in the portfolio, our best guess is 11.4%). Yet such a “modest” increase is also a return to normality after a prolonged period of supercharged growth driven by ever rising corporate debt levels. There are no grounds for complacency, but the runes suggest that the companies in the portfolio will continue to enjoy a gradual re-rating.
© Bedlam Asset Management
