Revenge of the dividends?
For many years, investors in the Nordic countries and around the world have rejected dividend stocks, especially in favour of growth-oriented companies. Monetary stimulus measures, weak economic growth and cancelled dividends have probably contributed to this, but we wonder whether this trend has now gone too far. We believe a diversified basket of high dividend yield equities in companies with relatively stable operations is an attractive investment alternative.
This is a summary – read a longer article on pages 19-23 of the latest Investment Outlook (pdf)
Dividends crucial to valuation
In theory, the valuation of a stock is determined by the present value of all its future dividends. Meanwhile equities, at least in theory, have no maturity date, making it difficult to forecast their dividends. But the lower the discount rate used to value future cash flows, the less it matters whether dividends are paid in the near future or at a later time. So it is natural that the steep decline in bond yields we have seen over the past decade has helped fuel greater investor appetite for growth than for dividends.
The downside of high dividends
Generous dividends can be seen as an indication that the company sees neither investment opportunities in its own operations nor opportunities for value-generating acquisitions. Most stocks with a high dividend yield (dividend/share price) are mature companies with low or negative earnings growth, a modest return on equity and/or capital employed and a relatively low PE ratio.
In the Nordic countries, the list of companies with a high dividend yield is topped by shipping companies, the oil business, telecom operators, banks and insurance companies as well as tobacco companies, fossil fuel power generation companies and automotive manufacturers. The picture is similar elsewhere in Europe, but more diversified and with a significant element of chemical companies with sustainability challenges. One common denominator for these companies and industries is significant uncertainty.
Many investors question, for example, the sustainability of earnings generation for companies whose operations are based on fossil fuels, which must now be phased out. Others refuse to invest in ethically questionable industries such as tobacco, see regulatory risks for the industry, or are simply scared off by negative volume growth.
“Dividends are not free money”
High dividend yields have a downside. This is not free money. The challenge for investors is to determine whether the attractiveness of dividends is greater than the concerns reflected in low share valuations.
A decade of underperformance
From a global perspective, stocks with a high dividend yield have generated weak returns compared to benchmark world indices over the past decade. The trend has accelerated significantly this year, probably driven by cancelled dividends, while expansionary monetary policy has fuelled the upturn of many equities with high valuation multiples and low or no dividend yield.
Still, this has not always been the case; from 2000 to 2007 dividend stocks far outperformed the total index. However, the relative outperformance of dividend equities began when the dot-com (IT) bubble burst, a trend initially characterised more by the poor performance of other equities than by their own strong performance. Dividend stocks had also lagged well behind the market during the 1998-2000 boom − just as they have lagged behind a strong stock market today.
Sooner or later, this time around too, there will be a counter-reaction. We see no really good catalysts for a turnaround in the near term, but we should not rule out the possibility of this taking place as early as 2021.
Dividends are important over time
Of the total return of 173 per cent for the OMXS30 index (the 30 largest equities on the Stockholm stock exchange) since 2000, dividends account for 130 percentage points. Elsewhere in Europe, the importance of dividends is even more apparent; of the 79 per cent return for the Stoxx Europe 600 index, dividends account for 89 percentage points. Furthermore, the contribution from dividends has been far more stable. For the OMXS30 during the 21st century, dividends have contributed returns of 15-18 per cent per five-year period while for the Stoxx 600 they contributed returns of 17-19 per cent. This is in stark contrast to the volatile contributions from share price fluctuations over the same period, which fluctuated between -20 per cent and +30 per cent per five-year period.
“Dividends account for some 130 percentage points of the total return for the OMXS30 index since 2000”
Is performance compared to an index important to you?
It is often assumed that the relative return on an equity investment compared to an index is particularly significant to investors. Compared to a broader equity index, it has not been a successful strategy to invest in high dividend yield stocks over the past decade, but this is not necessarily true of investors who see greater value in a somewhat steady cash flow from their investments − especially considering how difficult it is to generate similar returns from fixed income investments today.
Is the dividend yield sustainable?
Dividend yield as such is not a good valuation metric for equities. The relevant metric is dividend capacity over time. We believe there has been somewhat too much focus this year (and potentially in 2021) on dividends that are paid promptly, or more precisely the absence of such. Given the earnings trend we have seen, and current prospects, it is reasonable to assume that capital stored up during the crisis instead of being distributed should benefit shareholders a little later on.
An attractive situation for an unpopular strategy
After the very weak relative performance of high dividend stocks recently, it may already be a good time to buy now for investors with a time horizon of 3 or more years.
To reduce risk, such an investment should be made in the form of a diversified equity portfolio of stocks. Such a portfolio will probably underperform the relative index as long as current market sentiment persists but can still provide an attractive total return. However, stronger real economic growth is probably needed for this strategy to outperform the index.
We can identify 72 companies among the 600 in the Stoxx Europe 600 index that are expected to pay a dividend equivalent to at least a 6 per cent dividend yield for 2021 and 2022, after having eliminated companies with a low sustainability rating relative to their industry and the less sustainable half of all the companies in Sustainalytics’ risk ranking based on environmental, sustainability and governance (ESG) issues.
These 72 companies have an unweighted average dividend yield of 7 per cent for this year, 7.9 per cent for 2021 and 8.6 per cent for 2022. Most of these companies are questionable from some perspective, but obviously it is still possible to put together a relatively well-diversified portfolio of European equities with an expected high dividend yield.
This may be an attractive complement to a more normal portfolio of equities competing against an index and a good investment strategy over a period of several years for investors who value the relatively higher stability of cash dividends compared to volatile share price movements.