Wind assisted returns

March 1, 2021

1:47 pm

The ascendancy of the growth style of investing over the last decade has been unusual in its strength and duration. There are now signs that the winds of change are blowing through global equity markets. Read on to find out how RWC’s Global Equity Income strategy may benefit should the growth headwind become a dividend-investing tailwind.
A flight from London to New York is typically scheduled to take about eight hours. The flight back, however, typically takes less than seven hours. The simple reason for the big difference in flight times is wind! Flying west across the Atlantic means flying against the jet stream which represents a rather substantial headwind. Literally. But when flying east, from North America to Europe, the aircraft benefits from a tailwind. The return leg of the journey is wind-assisted, which normally allows the flight to be completed in a much faster time.

What if a growth-investing headwind…

Global equity markets have become growth obsessed. The US technology behemoths such as Facebook, Amazon, Apple, Netflix and Google are by no means the only growth stocks around, but they have come to represent a powerful and, for some investors, irresistible force in markets. Due to their sheer size and importance to US and global stock market indices, these high priests of growth investing have left practically everything else in their slipstream over the last decade.

Although many factors have contributed to this growth obsession, an enduring period of ultra-low interest rates has undoubtedly been an important engine. Official interest rates reflect the rate at which future cashflows are discounted, so a lower interest rate increases the value of future cashflows from equity investments. In theory, this should increase the current value of all equities, but it tends to favour growth companies, where a greater proportion of current value is deemed to be associated with future cashflows, more than it does those with traditional “value” characteristics, where more of the value is associated with the here and now.

Nevertheless, the longer this dynamic has played out in markets, the more stretched valuations have become among many growth stocks. The long history of financial markets suggests that there must eventually come a point at which the valuation stretch in markets starts to normalise. The valuation altimeters for many of the stocks that most closely personify this growth obsession make for scary reading, and the prospect of a nose-dive cannot be completely ruled out.

In the meantime, however, these conditions have inevitably represented a headwind for any investor unable or unwilling to embrace these stocks and others like them. Our disciplined investment approach means that we will leave them on the table. Our yield discipline prevents us from investing in any stock unless it yields more than 25% above the global average. That immediately screens these growth stocks which, as a result of their seemingly unstoppable share price performance, offer very little in terms of dividend yield, out of our investable universe. Irrespective of this distinctive yield criteria, however, our broader investment disciplines would prevent us from participating, given the substantial valuation risk that these stocks now entail.

Make no mistake, though – we do like some growth characteristics. We love to invest in quality businesses that can deliver long-term growth in earnings and cashflows. Just not at any price. It is the price that has become the problem for many stocks, not the concept of sustainable growth. Our entire investment process is designed to identify and invest in quality companies that can deliver growth at a time when they are not priced for growth. Each stock must deliver a premium yield, dividend sustainability and a valuation margin of safety. That is why we call it “Quality at a Reasonable Yield”.

We believe this disciplined process is robust and repeatable, and it has delivered outperformance over the last decade. This is a significant achievement in such a relentlessly adverse investment environment.

…becomes a dividend-investing tailwind?

An important consideration for investors at this juncture should be, how should an income-oriented strategy such as ours perform if the growth headwind turns into a tailwind? Increasingly, there are signs that the winds of change are already blowing through global equity markets.

Investors are sounding the alarm bell around the extreme valuations of technology stocks and other parts of the market that display classic ‘growth’ characteristics. Many people believe we are in bubble territory and are questioning the elevated share prices in parts of the market that have driven returns in recent years. For example, valuations of some of the big US technology companies have reached almost 10x sales. The combined market capitalisation of the five largest US stocks is equivalent to the third largest country in the world, with only the US and China’s GDP greater. The assumptions on future growth that will be required to enable investors to make a positive return from here are extraordinary. In fact, we would argue, they are basically impossible.

Certainly, they are not priced for anything to go wrong, which is interesting given that governments the world over are wrestling with how to raise taxes to pay for some of the extraordinary stimulus spent and promised. Corporation tax for the largest companies has fallen from 50% in the 1960s to below 20% today, and many of the largest technology companies pay 10% or less. It doesn’t seem inconceivable that corporates will be forced to pay a share of the costs of dealing with the pandemic, especially those that have benefited from it.

The wind beneath our wings

Within equity markets, therefore, income-oriented strategies look far less risky because they have not witnessed the same level of excitement and enthusiasm. Valuations, as a result, are much more attractive, and valuation still matters – eventually. The correlation between a high PE and subsequent one-year returns is low (an R2 of 8% suggests almost no correlation at all), but over five-years it is much higher (as measured by an R2 of 44%)*. From here, total return will have to be driven by another engine.

As a reminder, therefore, a wide body of evidence demonstrates that the power of compounding a sustainable dividend has been a successful investment strategy for more than a century. We believe that this will prove to be a more enduring force in equity markets than the current infatuation for over-paying for growth characteristics.

If we are to see a tailwind for dividend-based strategies, the next ten years will look markedly different to the decade that has just passed. The flight path therefore looks encouraging for our strategy. Similar to an eastward bound aeroplane flying across the Atlantic towards Europe, a tailwind in markets should allow disciplined dividend-based strategies to deliver their investors to successful destinations even faster.

Chocks away…
* Source: JP Morgan as at 31 December 2020.
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