In today's low-yield environment, Hans-Jörg Naumer says dividend strategies can be a key performance driver for investors' portfolios— and they can play a role as an anchor of stability amid increased market volatility.
Capital income: Dividends
In a large number of advanced countries, the current yields of governments bonds are hovering in negative territory or, at the very least, are at an insufficient level to preserve capital. Consequently, attention is increasingly shifting to dividends as a way of generating capital income. Indeed, dividends are becoming even more relevant as the issue of "reflation" comes to the fore with a gradual uptick in inflation rates.
As at the end of 2016, approximately 28% of all government bonds of advanced economies in circulation sported negative yields, as shown by our Allianz Global Investors QE Monitor. The situation is particularly dramatic in Japan and Europe. However, by the time investors factor in the effect of inflation, it becomes clear that nominal yields in other parts of the fixed-income universe are not sufficient to preserve real purchasing power, either. Although current yields may well be positive in the US, for example, real yields (nominal yields minus the inflation rate) are negative, and this even applies to maturities of up to 10 years. If you save in this way, you are certain to lose purchasing power. An investment such as this is not appropriate for maintaining purchasing power and most definitely not suitable for accumulating capital. Thus, it is understandable that dividends are increasingly viewed as the new "interest on equities," despite volatility being a fact of life with equity investments.
Dividend strategies certainly appear interesting amid an environment of negative, or at least low, yields. Divergence between dividend yields and yields on government and corporate bonds has never been as large as it is today by historical standards, at least as far as European companies are concerned. For investors, there are two key questions that are important to consider before any assertions can be made about the future success of dividend strategies:
1. What advantages can dividend strategies offer the long-term investor?
2. Taking the current market environment as a starting point, what can be expected in terms of the future performance of dividend yields?
Dividends: A key performance driver in a low-interest and low-yield environment
European companies, in particular, have an investor-friendly dividend policy compared to their international peers. At the end of 2016, their average dividend yield across all market segments was around 3.5% based on the MSCI Europe Index. Focusing on high-dividend stocks meant that the expected dividend yield in portfolios rose even further. However, in some cases the dividend yield in other regions is considerably higher than that on 10-year government bonds, too. (See Exhibit 1.)
Exhibit 1: Dividend yields are attractive around the globe
Dividend yields (MSCI Indexes) and interest rates of 10-year government bonds
Past performance is not an indication of future results.
Source: Datastream, AllianzGI Global Capital Markets & Thematic Research as of 12/30/2016.
Companies from the euro countries of Spain, Portugal and Italy are heading the field, which can be explained by the fact that these markets still have low valuations. The dividend yield on the MSCI USA Index seems positively modest in comparison, although you have to bear in mind that US companies, in contrast to European ones, for instance, have a stronger tendency to launch share-buyback schemes than to pay out dividends. Share-buyback schemes, though, are nothing other than corporate profits being paid out to a smaller, residual circle of shareholders.
Dividends: Stability for portfolios
At the same time, what is noticeable is that dividends can potentially help achieve additional stability in portfolios. In the past, investors in European equities were the main beneficiaries of high-dividend payouts that also helped in stabilizing the overall performance in years of declining stock prices. Dividends were able to partially or even totally compensate for any price losses. From 1971 through 2016, the performance contribution of dividends to the annualized total portfolio return for the MSCI Europe Index was approximately 38%. But in other regions, such as North America (MSCI North America Index) and Asia-Pacific (MSCI Pacific Index), around a third of overall performance was determined by dividends, albeit the absolute dividend yield was lower here.
However, dividends alone cannot ensure more stability with equity investments. High-dividend equities in themselves seem to have a less-volatile performance than those of companies with lower dividend payouts. This is demonstrated by analyzing the past performance of US stocks, using the longest available time series. This analysis shows that since 1972, the volatility of US equities (measured in terms of a 36-month rolling standard deviation as a gauge of price fluctuation) has been lower among companies paying out a dividend than among stock corporations that did not distribute any profits. Analogous behavior is also discernible for European dividend stocks since the 1990s.
Reasons for the value and price stability of dividend-bearing equities include, among others:
- Dividend policy is often an active component of a company's strategy. The dividend sends out an extraordinarily strong signal. Reaction on the market to reductions in or the absence of dividend payouts is very negative, since they sow doubts as to the future viability of the company. Consequently, companies go to great lengths to guarantee continuous dividend payments. A comparison of dividends and profits of members of the S&P 500 Index since 1956 shows that corporate profits have been subject to far greater volatility than dividends. Particularly in the last 10 years, the volatility of profits has been considerably larger, at almost 60% on an annualized basis, than the fluctuation observed in the case of dividends, which has been around 6% per annum.
- Higher dividend payouts and a desire to reliably and continuously maintain them due to the signal they send out have a tendency to discipline companies. They are forced to manage their financial resources prudently and to use them efficiently. In contrast, share-buyback programs, due to their discretionary nature, neither have a comparative signal effect nor a similarly disciplining impact on the company.
- Companies with high-dividend yields usually have sound balance-sheet ratios with a relatively high level of equity capital and stable cash flows.
Looking ahead: How sustainable are dividends?
The lessons of the past, however, must be put into the perspective of expected future performance. Current dividend yields only describe the status quo, but not what an investment in equities can actually achieve.
Factors suggesting stable or even rising dividend yields in the current market environment are:
1. While the ratio of dividend payout to earnings per share, at around 80%, is considerably above its pre-crisis level in Europe at the moment, the distribution ratio in the US and Asia, at approximately 50% and about 45%, respectively, is more modest. Therefore, there is still scope for companies in these markets to boost dividends in the future.
2. Currently, companies have a large amount of free cash flow at their disposal. For example, the net cash flow of US companies in relation to US gross domestic product is 12%, and may be approaching the record level seen in 2011. (See Exhibit 2.)
Exhibit 2: US companies are holding substantial cash
Net cash flows of US companies relative to US gross domestic product
Source: Datastream, AllianzGI Global Capital Markets & Thematic Research as of 1/3/2017.
3. Our global market outlook suggests that capital markets are gearing up for reflation, as economic indicators are improving, not least thanks to an expected fiscal stimulus in the US. These factors mean better prospects for corporate profits. At the same time, additional interest-rate hikes can be expected from the US Federal Reserve. The latter, coupled with inflation rates, which are once again on the rise, underpins expectations of weaker bond markets and stronger equity markets.
4. Solid yet low global economic growth and the prevailing (as of December 2016) valuation data for the world's major equity markets suggest that dividends will contribute a significant share toward the overall performance of equities.
5. Regarding the profit outlook for 2017, supportive factors outweigh negative ones. In the US, a recovery in the energy sector, expected tax cuts and spending programs, among other things, should leave their mark on profits. On the other hand, the appreciation of the US dollar and pressure on margins as a consequence of higher unit labor costs will have an adverse effect. Companies in the European Union should also benefit from the US fiscal stimulus, albeit only indirectly through higher economic growth, as well as from a recovery in the energy sector and—most likely—the banking sector. Political uncertainty should have a negative impact. It is unlikely that analysts' consensus estimates in relation to profit increases will be fully met.
6. Since increased volatility can be expected in the context of monetary policy and the global geopolitical situation, dividends could potentially play their part as an anchor of stability.
Hunting solely for high-dividend payments, though, can be misguided. Rather, in addition to a shareholder-friendly policy, it is particularly a company's business model that can justify expectations of sustainable returns. Factors such as market share, market-entry barriers or the power to dictate prices play an important role in this regard. The right business model would also allow such companies to cushion the effects of inflation by raising prices.
Contributing author: Dennis Nacken
For more information, read Capital Income: Dividends.
Investors fixated on China's macro issues could miss the bottom-up opportunities in a market with more listed companies than the US, says our Asia-Pacific equities CIO. Rewards abound for investors who grasp the size and subtleties of fast-changing China.
A bottom-up story
When many investors think about China today, they focus on a few well-publicized macroeconomic concerns: property bubbles, non-performing loans in the banking system or the renminbi's weakness against the US dollar. In our view, these are all valid issues, but we see investing in China as more of a bottom-up story— one that can reward active investors who understand the size and subtleties of a booming marketplace.
We see investing in China as a bottom-up story that can reward active investors
Consider that there are now more than 4,200 Chinese companies listed on stock exchanges around the world mostly in Shanghai, Shenzhen, Hong Kong and the US— with a total market-capitalization size of $10 trillion. That means there are more listed companies in China than in the US. As in the US, the sheer size of this group means there are always promising companies to be found. But unlike in the US, many inefficiencies still exist in China’s equity markets— and it is here where active managers have an opportunity to deliver alpha to investors.
With a total market-cap of $10 trillion, China has more listed companies than the US
Shanghai vs. Shenzhen
For example, China's equity markets— A-shares, H-shares and American Depositary Receipts (ADRs)— behave quite differently. The Shanghai and Shenzhen markets in particular are influenced more by local factors particular to their business climates: Shanghai is more represented by old-economy sectors, such as financials, while Shenzhen is dominated more by new-economy sectors, such as technology. Meanwhile, H-shares and ADRs are more influenced by overseas sentiment on China. This enables astute active managers who are focused on fundamentals to exploit these differences and add another source of alpha potential.
Many inefficiencies exist in China’s equity markets—which is where active managers can find alpha