Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here, JP Morgan portfolio managers Philippa Clough and Thomas Buckingham highlight the potential for earning income from European stocks.
Even seasoned dividend investors might be surprised to realise the potential in Europe—dividend yield alone makes up 30% of the Europe index average annual return.
As a quick example, consider an investment in the MSCI Europe Index from 1969 through to today. The price gains alone would equate to sizeable growth worth some 17 times the initial investment. However, if reinvested dividends are also accrued, then the investment would have grown to an impressive 60 times the initial value.
The appeal of dividend investing is obvious—the certainty of income today is better than the uncertainty of future price gains—but the question for investors is whether higher yields also equate to higher returns?
In the case of high yielding European stocks, dividends can be a good indicator of relative value. The highest yielding (that is, the cheapest) segment of the market tends to outperform the broader market, suggesting that market participants tend to be too pessimistic when they value these companies. History teaches us that most of the capital gains for high yielding stocks come from the valuation re-rating—meaning that the market eventually corrects the initial under-pricing of high yielding stocks. This factor combined with superior yield helps dividend-paying stocks to do better on average than the rest of the market.
As well as delivering better returns, dividend-yielding companies also tend to be less volatile. In Europe, stocks that do not pay a dividend are on average 50% more volatile than those that do.
So how should investors access Europe’s dividend premium? Thomas Buckingham, fund manager, JP Morgan Funds—Europe Strategic Dividend utilises an investment strategy that focuses on the highest yielding 30% of European stocks. He looks for attractively valued, high quality stocks with positive momentum that can outperform the market and seeks to avoid dividend traps. In other words, he doesn’t invest in stocks that have unsustainable yields or weak momentum. This leaves him with a diversified style driven portfolio that maximises dividend exposure.
He points out some current key themes of his investment approach:
- In terms of sectors, we continue to like insurance, real estate and utilities. These positions are the result of a large number of stocks in these sectors continuing to offer high dividend yields, supported by positive newsflow and the ability of the companies to continue paying dividends;
- In comparison, we are underweight the food, beverage & tobacco, pharmaceuticals and capital goods sectors, where we do not hold a number of stocks with a large benchmark weighting that either do not offer a high enough dividend yield or look like yield traps;
- In terms of our outlook, although lead indicators remain mixed, the overall picture seems to be improving in Europe. Valuations are supportive, and balance sheets remain very healthy.
Philippa Clough, portfolio manager, European Equity Group—Behavioural Finance Team concludes that certainly dividends are at the heart of equity investing, but it’s hard to overstate their importance in European equities, where investors are rewarded for focusing on high yielding stocks. History demonstrates they have undoubtedly outperformed the market on average. Investors can enhance dividend returns by excluding yield traps and focusing on companies with a sustainable yield.
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