In a challenging economic environment, where can income investors find companies that can grow and sustain dividends? Richard Saldanha answers the big questions.
Read this article to understand:
- Why we expect dividends to hold up well in the coming months
- Which geographies and sectors remain attractive
- How dividends can offer protection against inflation
Market volatility is not likely to go away anytime soon. The war between Russia and Ukraine grinds on; Europe is reeling from the impacts of the energy crisis; and China’s growth is slowing due to the Beijing government’s stringent zero-COVID policies.
Nevertheless, dividends have continued to grow strongly in 2022. Global payouts to shareholders hit a record quarterly high during the three months to end-June, mostly driven by bumper dividends in the oil and gas sector; banks and consumer goods companies also grew their dividends over the period.1
But dividend growth looks set to moderate as rising inflation and interest rates begin to weigh on consumer spending. The strength of dividend increases among US companies had begun to decline as of September, according to analysis from S&P Dow Jones Indices.2
In this Q&A, Richard Saldanha, lead manager on the Aviva Investors Global Equity Income strategy, argues investors should focus on the sustainability of dividends as a way to navigate this turbulent period.
Global dividends have held up remarkably well this year, despite a challenging market. Do you expect that to continue given rising borrowing costs and inflation?
Yes. Corporate balance sheets are in much better shape than in prior downturns. Companies are generating good levels of free cashflows, which is key when it comes to supporting dividends. This provides reason for optimism that global dividends can hold up well.
While we expect moderation in dividend growth, as earnings are coming under pressure, there are still many companies that can maintain and grow their dividends even in a sharp downturn.
But investors should be discerning given the uncertain macroeconomic environment. The firms that are going to be challenged the most, if the situation continues to deteriorate, are in cyclical parts of the market, such as banks and some consumer discretionary names. That’s why we're keeping a close eye across sectors.
Unsurprisingly, given the challenges of the past few months, investors have turned from growth to income as a source of portfolio resilience. Does income now look expensive on a relative basis?
No, we would argue certain elements of the income universe still look attractive. The more defensive parts of the market (pharmaceuticals, consumer staples, utilities and telecoms) have outperformed as investors seek shelter amid the ongoing market volatility.
More growth-orientated sectors have suffered and that's where the real value is
On the flip side, more growth-orientated sectors (such as technology, industrials and consumer discretionary names) have suffered – and that's where the real value is. This is where we see opportunities on a relative basis: in companies and sectors with resilient business models and good growth prospects, which still offer compelling free cashflow and dividend growth potential.
Have you made any adjustments to the portfolio since we last spoke?3
We have taken advantage of market volatility to add companies with resilient business models that are seeing structural growth in their end markets. Pest-control company Rentokil is one of these, as it proved to have a defensive business model in prior downturns. The pest-control industry is resilient – if you have a pest infestation, you must deal with it whatever the macroeconomic situation. Volumes have also grown thanks to long-term trends such as increasing urban density and warming temperatures, which are leading to more pests.
We have taken advantage of market volatility to add companies with resilient business models
Another example is payment processing firm Visa, a cash-generative business with a solid balance sheet and a natural hedge against inflation thanks to rising payment volumes. The increasing penetration of digital payments and e-commerce – in developed countries, but even more so in emerging markets – is a fantastic structural growth angle for this company.
These stocks have sold off this year despite having resilient businesses and exceptional income growth prospects. When the market pivots defensively, we often lean into growth, and vice versa, but still with a focus on capital protection. Where we see long-term value three to five years down the line, we are very happy to be contrarian.
Looking at the market overall, which geographies and sectors remain attractive? And which are struggling?
From a geographical standpoint, the US remains relatively attractive, given the ongoing Russia-Ukraine war, the impacts of energy shortages in Europe and the zero-COVID policy in China. The US has offered investors shelter from the storm, as the domestic consumer has not felt the same energy cost pressures as those in other parts of the world.
However, from a valuation standpoint Europe certainly looks interesting. We have been happy to invest in companies like Rentokil, which is UK-listed but is looking to take advantage of growth opportunities in the US. A good example is its recently announced acquisition of US peer Terminix.
We believe technology and industrials offer long-term value
Sector-wise, we believe technology and industrials offer long-term value. Investors have flocked to more defensive sectors and, while it is understandable given the heightened uncertainty and volatility, there is currently a real dislocation between underlying company fundamentals and share prices. We are focusing on “mispriced resilience” rather than leaning into cyclical companies. Our interest is in companies where we have confidence in the underlying business, irrespective of the macroeconomic outlook.
The consumer discretionary sector has been under pressure as consumers feel the pinch from rising energy costs and inflation, which is likely to continue during the coming quarters. Technology stocks have also experienced pressure, but this has more to do with their valuation multiples being affected by rising-rate expectations than the underlying fundamentals of the sector.
There seems to be a disconnect emerging between the bond and equity yields for the same company. For example, certain bank bonds can be bought at a heavy discount on a ten per cent yield, versus 4.5 per cent for the equity. Does this matter?
We don’t believe it matters in terms of long-term value. The dividend yield is not a good barometer for value, but free cashflow yield is. The strategy currently has six per cent free cashflow yield, which we view as attractive given the underlying growth prospects and resilience of the companies we target.
We focus on a company’s ability to compound free cash flow growth over time, ahead of inflation
Of more significance, we think the companies in the portfolio can continue to grow dividends at mid to high single-digit rates, which should offer protection against inflation (which importantly bond yields do not). We focus on a company’s ability to compound free cashflow growth over time, ahead of inflation.
Banks are a good example of why investors cannot purely focus on yields: in the past, they have had to cut dividends during economic downturns. Investors need to think about the sustainability of dividends. This is why, within the financial sector, we prefer insurers, insurance brokers and stock exchanges to banks. By investing in these companies, you can still benefit from rising yields or interest rates, but there is much lower risk of dividend cuts.
What are the key themes income investors need to be looking out for in the coming months?
All eyes will be on Europe; in particular, how the continent will deal with energy shortages during the winter. These challenges could create opportunities for companies that aspire to play a key role in the energy transition. For example, European industrial companies Schneider and Siemens offer products that help reduce the energy consumption of buildings and support the digitalisation of electricity grids. Smart grids can manage baseloads more efficiently as we come into the winter and enable a pivot towards new energy sources.
Companies that offer solutions to these ongoing challenges stand to benefit
Another area of interest is around ageing grid infrastructure, as extreme weather events are putting greater stress on electricity grids. Companies such as National Grid in the UK, which focuses on transmission and distribution networks, and Hubbell in the US, which develops products to strengthen grids against storms and natural disasters, will have an increasing role to play as extreme climate-related events become more frequent. These are themes that will play out not just over the coming months, but over the coming years. Companies that offer solutions to these ongoing challenges stand to benefit from the need for further investment.