Why global equity income works

For investors looking for a consistent income stream that grows over time, global equity income has the fundamentals covered, writes Stephen Thornber. 

Investing for income is not a new strategy. And the experience of the global financial crisis only added to its appeal.

As growth assets collapsed, advisers moved quickly to shift clients’ portfolios to the safe haven of defensive investments like cash and fixed interest.

Six years on, income is still a priority for investors, particularly those heading into retirement, but with global economic growth sluggish and interest rates at historically low levels, it is becoming difficult to find an income stream which delivers.

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As our population ages, investors need their income in retirement to last longer, and more importantly, to keep up with the cost of living. 

So where should you be looking for consistent income streams which grow over time? 

Companies with good fundamentals, robust business models and strong balance sheets grow their dividends over time, rewarding investors for their investment and providing an effective hedge against inflation.

Here are the top 10 reasons that advisers should seriously consider global equity income for their clients.

1. Equity income strategies have outperformed equity markets

Dividends and dividend growth drive total real returns from equities; in fact they account for 80 per cent of return over time. In the current low growth environment, which we anticipate will continue, it is likely that dividends and dividend growth will account for an even greater percentage of returns.

2. Income investing adds performance consistently

Equity income strategies may have been out of favour at certain times, but the fact remains that they have proven to be consistently successful, regardless of broader stock market or macroeconomic conditions.

Research shows that not only have dividend stocks outperformed the market generally, but the higher the yield, the greater the outperformance.

3. Income investing provides inflation protection

Ever since the US Federal Reserve began its program of quantitative easing, many analysts have been predicting that the results would be inflationary.

This may not happen, but it’s fair to say that we have just lived through one of the largest monetary policy experiments of the last 300 years. 

If inflation does pick up, even modest dividend growth of 5-6 per cent will provide some protection, and we believe that many companies will be able to grow their dividends by a larger percentage than this over the next few years. 

In addition, equities also provide the possibility of capital growth, which fixed income doesn’t, and this also shields against inflation.

4. Equity income investors go for long term

Because reliability of yield and the ability of a company to grow dividends over time is the major focus of successful equity income investors, they must by necessity look at the long term. This requires a long-term perspective, not chasing the latest trend.

5. Income investing a good financial discipline

Companies with the ability to grow dividends are usually well-managed, with an executive team able to create value and in control of the company’s destiny. A high yield is important of course, but this isn’t the only factor.

The big question is whether or not the company can make a profit and pay a dividend. When the market is volatile, it’s particularly important to focus on the fundamentals – good stock picking is vital. We look at good free cash flow, sound management teams and reasonable valuations.

6. A global approach provides wide opportunity

Global investors have access to the fastest-growing economies as well as sectors which may be profitable in one country, but not in another.

At the asset allocation level, this means that the portfolio can be tilted to the fastest-growing economies and industries, wherever they are.

For example, Asian utility companies are currently benefitting from population and economic growth as well as government drives to expand infrastructure. Utilities in the UK and Europe, on the other hand, are operating in a mature economy and are heavily regulated, with little population growth and a slow growth economy.  

7. Dividend payout levels are sustainable

In stark contrast to many governments, globally, many corporates have done a very good job of repairing their balance sheets in recent years.

On the flipside, the harsh experience of the global financial crisis means that they remain cautious and are not committing to large-scale capital expenditure. We expect expenditure to pick up as economic conditions improve, but not in the short term.

Because so many corporates have free cash flow which they have been reluctant to reinvest, they have been using this cash in very shareholder-friendly ways, by increasing dividends, paying special dividends and via share buybacks.

We do look for companies with comfortable dividend payout levels, as we don’t want them to ‘play to the crowds’ with excess and unsustainable levels of payouts. 

Ultimately, we have confidence that current payout ratios can be sustained. This is because the corporate sector is in good health and cash generation has been so positive. 

8. No sign of an income bubble

Given the quantitative easing-driven repression of bond markets and several years of strongly performing equity markets, investors could be forgiven for thinking that income stocks must be in a bubble. 

The reality is that we don’t see any evidence of an income bubble anywhere around the world. In fact, high dividend paying companies around the world are still trading at a discount to the broader market. 

One possible exception is the US market, where dividend paying stocks are now more expensive than in other parts of the world.

As a result we are taking particular care when selecting companies in that market. However, in our view, valuations are still not stretched.

9. Boring can be exciting

Owning what the market perceives to be boring isn’t necessarily a bad thing.

For examples, stocks with high barriers to entry in their industry, and which have the ability to use their financial strength and market position to maintain high returns and grow their dividends, can add significant performance to a portfolio.

This is particularly true when these stocks are blended with other stocks to create a portfolio that can perform in a wide range of economic and market conditions.  

Needless to stay, these stocks need to be purchased at the right valuation.

10. Equity income offers great opportunities

In addition to dependable, high-quality companies, successful income investors need to be able to be contrarian investors.

This means looking for re-rating opportunities where cashflow can surprise to the upside, rather than just buying stocks which offer a big yield.  

In the same way, companies which have cut their dividend shouldn’t be automatically excluded from consideration.

Ultimately, investing for global equity income can be a great way to help clients achieve a consistent income, which with the right portfolio of stocks, can grow over time and provide the upside of the potential for capital growth as well.

For our money this means a genuinely diversified portfolio, by geography and industrial sector, but also by income.

A combination of different types of income-generating companies is key, which means a combination of compounders, long-term growth companies, cyclical companies benefitting from a pickup in the economic growth cycle, secular growers, and those engaged in long-term growth trends within the broader economic sector.

When combined into a structured portfolio, investors can expect their income returns to grow over time, and even more importantly keep pace with their cost of living.

Stephen Thornber is a fund manager in the global equity income division at Threadneedle Investments.