There are many reasons an investor should prefer to buy an asset that has fallen in price. Among the many benefits, an investor obtains greater earnings power for the price, greater balance sheet ownership for the price and greater cash-flow generation. But increasingly the most popular reason an investor wants to buy cheap assets is the desire for yield.
Dividends and buy-backs influence Morningstar Investment Management’s thinking in a major way, although we would go a step further by redefining it as a desire for sustainable and growing dividends. This illustrates the importance of payout levels, with a love for assets that have the capability to pay strong dividends that are going to grow.
In the current backdrop, we find the best opportunities – such as emerging markets, European financials and European energy – also have some of the most attractive payout policies. This can be countered against the most unattractive opportunities – U.S. growth stocks, information technology stocks – which offer some of the lowest dividends. This relationship is not a coincidence.
To demonstrate the collective power of dividends to our long-term valuation framework, below we depict our 10-year valuation-implied return forecasts across the 198 markets. This shows the average dividend yield of our favoured basket of assets is more than 3.5%, while our least favoured is closer to 2.2%.
Dividend Sustainability can be a Concern
Unfortunately, the downside to the drive for yield is that companies are succumbing to share-holder demands and increasing payout levels. The fear is that if this trend continues, we may find ourselves in a position where dividends are unsustainably high and thereby become a source of risk as opposed to value.
Let’s take the U.K. as an example. Historical evidence shows that the average company in the U.K tends to payout approximately 50% in dividends, with the remaining 50% re-invested in the business. Yet the past 12-months has seen U.K. companies pay out 109% in dividends, leaving nothing to re-invest in growth opportunities.
Japanese companies are far more conservative in this regard, but even these companies have increased the risk profile of their dividend policy. The past 12-months saw Japanese companies payout 37%, whereas they have historically paid out only 18%.
It begs the question of how and why they have allowed this to happen. The first point to make is that global companies have had a tough time deriving profit in the last five years, with the commodity crash causing earnings growth to fall across many countries and sectors. In fact, earnings growth at a global level has modestly fallen over the past five years in real terms by 2.26% a year.
Yet despite this headwind, corporate dividend policy continues to grow, with the same five-year period seeing dividend growth of 5.54%. In a long-term context, an investor needs to understand that this policy is increasing the sensitivity to earnings instability. For instance, if the average U.K. company suffers a further fall in earnings growth – which is perfectly feasible over shorter time periods, the payout ratio will continue to exceed earnings and dividend cuts could be inevitable.
There are a variety of ways to understand the relationship between dividend sustainability and earnings strength, and one of the more powerful methods is to consider earnings under the spotlight of return-on-equity. We can see that the U.K. has seen a material decline in the average return-on-equity, which largely explains that the dividend sustainability issue is more of an earnings problem than a corporate governance problem.
The good news is that some pockets of the world are sustaining healthy dividend policies relative to earnings, which is a source of optimism and provides a natural preference towards these assets. Emerging markets and Asian developed countries are conservatively positioned in this regard, which provides a platform for sustainable growth drivers as they can increase payouts or re-invest in growth opportunities.
Emerging markets in Asia have also managed to maintain remarkably consistent profit margins in the 7-8% range amid the commodity volatility. This is unlike other emerging market regions; such as Latin America and Eastern Europe, which appear far more sensitive to revenue changes.
