Investors too often rely on easy rules of thumb when making important capital allocation decisions. For example, an oft-repeated maxim is that the dividend yield determines future return, making it a powerful measure when choosing between stocks or stock markets.
Yet, when it comes to applying this thinking, many investors struggle – whether they are falling into value traps or missing out on capital growth, capturing dividends becomes problematic.
Over the years, Morningstar Investment Managament has spent a lot of time investigating the impact dividends have on returns and we feel certain that investors would do better to look beyond the headline yield. Dividends matter, but more important are two key factors: the sustainability of dividend growth and total payouts.
Looking back at the evolution of the sector is an interesting way to see the problems that chasing the headline yield can lead to.
Technology and healthcare stocks, for example, have historically offered high payout growth despite a low headline yield. This differs markedly from utilities and telecommunications, which have offered a high headline yield but with low payout growth. The predicament for investors is to balance these variables in a forward-looking context.
Of course, the rear-view mirror is always clearer than the windshield. Looking forward, it is worthwhile asking yourself whether technology and healthcare can continue to grow at rapid rates. One danger when casting such judgment is a recency bias, where investors put more emphasis on events that have happened recently, rather than considering the long-term picture.
Dividend Growth Stable in the Long Term
The past decade includes a major commodity slump that saw the likes of energy and materials struggle. An interesting way of looking through some of this dividend cyclicality is to group dividend growth by, what Morningstar has named, Super Sectors. The evolution of dividends is actually quite stable when you remove sector preferences and focus on the long term.
The sustainability of payout growth is a source of contention and, quite frankly, is impossible to predict with precision. For instance, Apple (AAPL), Google (GOOG), Facebook (FB), and Microsoft (MSFT) together make up around half of the tech sector alone, so the success of the sector becomes dependent on the evolution of these few companies.
We also need to acknowledge the capital cycle when considering payout growth. This underlines an important point, as capital expenditure and competitive pressures can materially impact payout sustainability. Ideally, this should be done on a sector-by-sector and country-by-country basis. For example, our fair value estimates reflect a slightly higher payout growth rate for technology stocks than they do for, say, utilities.
This can also impact the sustainability of payouts at a country level. To pick a few extremes, US equities have a structurally high exposure to technology at around 25%, while Italy has a negligible exposure. Moreover, Italy is structurally more exposed to financials and energy, accounting for approximately 55% of its total market cap. These sector weights can meaningfully change the payout sustainability at a country level and should carry weight when casting judgement.
Bringing this together, we depict our 10-year return expectations by global sectors, combined with the headline dividend yield. As investors begin to understand the fundamental attraction of an asset, they will begin to realise it is about more than picking the highest yield. It is a combination of total payouts and valuations that will ultimately drive returns.
