This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Ben Lofthouse and Andrew Jones, co-managers of the Henderson Global Equity Income Fund discuss why sustainability is important when it comes to income
In the current low interest rate environment investors are increasingly looking to equities for an attractive level of income. We are advocates of equity income investing for long-term total returns, and there are still lots of interesting opportunities around the world. Investors, however, should be wary about simply looking for the highest yields on offer. History shows that dividends from the highest yielding stocks can often be unsustainable.
That is one of the reasons why we believe investing across a diversified list of moderate paying companies, with the potential to offer both dividend and capital growth, is the best approach.
Sustainable Yields
The chart looks at the sustainability of dividend yields across developed markets between 1995 and February 2014 and highlights the risk of chasing high yields without considering the underlying strength of the company. It shows that in general, an estimated yield above 5% is less likely to be realised than a forecast yield of 5% or below.
This is because high-yielding equities can be more risky than their lower-yielding counterparts, particularly after a period of strong market performance, as has occurred over the last year. The high-yielding companies that are left are often structurally challenged businesses or companies with high payout ratios (distributing a high percentage of their earnings as dividends) that may not be sustainable.
Avoiding 'Value Traps'
An investor simply focusing on yields may end up owning a disproportionate percentage of these companies, which are often known as ‘value traps’. An active stock picking approach to equity income investing allows fund managers to analyse and understand which higher yielding companies may have been undervalued by the market. Investing globally will, in addition, offer a large universe of income stocks to select from, providing greater potential for diversification.
Stock Picking
For the income investor, the skill is to know where to look. Dividend yields can vary between regions.
The US and Japan, for example, are relatively low yielding, around 2%, whereas areas in Europe and Pacific ex-Japan offer around 3.5% and upwards. In Europe, as a result of the difficulty the region has endured, a large valuation opportunity has presented itself, but with stabilising economic forecasts the gap is likely to reduce.
There are still plenty of opportunities for income investors with a global universe of more than 1,000 stocks in the MSCI World Index that currently yield 2 per cent or more. Interestingly, the first edition of the Henderson Global Dividend Index revealed a trend of more companies in emerging markets and the Asia Pacific region paying dividends to investors.
While income is important, one of the core attractions of equity investing is the ability to select companies that can grow over time and in the process generate capital, increase earnings, and subsequently grow dividends. It is encouraging to see that many global companies are in very good shape with strong balance sheets and disciplined management teams focused on good cash flow, which should be supportive for dividend growth in the long run.
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