13 Jul 2021
Jacob de Tusch-Lec
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Yes, I think so. Ten years ago, in the wake of the financial crisis, with interest rates and bond yields moving to zero – or even below – we thought dividends on income stocks looked attractive and represented a good opportunity. But, particularly through 2018 and 2019, the market increasingly took a different view and liquidity poured into growth stocks, bypassing stocks that pay high dividends.
Today, growth stocks trade on elevated multiples relative both to the wider market and to their own history. Dividend yields overall are compressed, but we still see some pockets – pharmaceuticals, infrastructure, industrials and even some consumer staples – that offer 4%-5% yields. In a world where 10-year US Treasury yields are only 1.5% (and those on high-quality corporate bonds not much higher) this looks very attractive, particularly given that some ‘classic’ income sectors – low-growth but high-yielding names that have not done particularly well over the last decade – seem likely to benefit as fiscal stimulus displaces monetary policy as the main tool for steering economies.
This is a key question and one we are likely to be asking ourselves every day for the next few years. Although risks remain, particularly around emergence of new variants, we can start to think about the post-Covid world. What will this world look like? What kind of financial regime will it entail? Perhaps one in which there is more reliance on fiscal rather than monetary policy? And, crucially, which sectors will benefit?
We are style-agnostic investors, but it’s still interesting to look at the remarkable change in the style factors leading the market shown in Chart 1. There has been a marked change in the type of stocks leading the market since November, when trials shown vaccines against Covid-19 to be effective. Many of the factors that were negative in 2020 – including ‘dividend yield’ – have performed well so far in 2021.
As economies reopen, some of the traditional income sectors – hotels, toll roads, and airports – will come back into play. Elsewhere, some mining companies have come out of Covid with little or no debt on their balance sheets and high free cashflow yields and so may come to the attention of global income funds.
In terms of structural shifts, we anticipate a more general regime change. The 10 years since the financial crisis saw many extraordinary developments – bond yields close to zero, general inflation in asset classes, growth in global trade. But the post-Covid winners may look quite different…
The West’s intellectual commitment to austerity has been shattered and replaced by a willingness to support industries and consumers through debt-financed spending.
With governments encouraging investment there is likely to be a capex boom. This should support raw material prices and advantage labour over capital. Having bailed everyone out, governments have more power and influence than they did before the pandemic. This isn’t necessarily bullish for equity markets. Taxes could rise. There will also be some reversal of trends in globalisation and supply chains are likely to be shorter. Inventories may need to be higher. We think the next few years look more like 2003-08 than the decade that followed the financial crisis.
Companies tended to take advantage of low bond yields to de-lever through the crisis. Most of the companies in our portfolio actually have less debt today than they did before Covid. In one sense, that’s good news for dividends. But equally, they need to be cautious. They can’t simply return excess cash to their shareholders. Taxes may need to rise and ‘on shoring’ might oblige them to invest to build factories closer to their end markets. So we don’t expect a boom in dividends.
In the short term, those sectors that can benefit from disruption post-Covid and who can earn supernormal profits (transportation stocks, for example) are attractive. But we are conscious this won’t last forever; we must be prepared to move on.
Regionally, we favour the US slightly more than we did before the crisis – and Europe rather less. European companies tend to pay dividends just once a year and felt more intense pressure to cancel or suspend their pay-outs. Unfortunately, Europe’s dividend season last year came near the height of the pandemic and in many cases, pay-outs were cancelled outright, meaning shareholders missed out on a whole year of income.
In contrast, US companies tended to cancel share buybacks – but kept paying their dividends. Moreover, they pay their dividends twice or even four times a year; so cancelling one of these pay-outs had a smaller impact.
Interestingly, however, the boards of European companies usually cancelled dividends for political reasons (it would have looked bad to reward shareholders at a time governments were propping up economies) rather than out of financial necessity. At some point, those dividends can return when it is deemed socially acceptable. Once greater clarity emerges, that will offer interesting opportunities – and dividends. Needless to say, this is something we are monitoring closely.
We always try to be unconstrained and look for dividends in all areas of the market. But at the moment we are looking at sectors that have been disrupted by the pandemic and so where earnings have the potential to bounce back for the next couple of years. One such is chemicals, where we are now overweight for the first time in many years. Disruption in the supply chain means there are shortages of various raw materials such as, for example, those needed to make ‘greener’ plastic. We now own BASF and Covestro.
Another area is transportation, where disrupted supply chains and under-capacity meant shipping rates increased sharply. Disruptions have been so dramatic that free cashflow yields for these companies have risen dramatically and we suspect they may stay higher for longer.
The combined effects of a number of these forms of disruption can be seen in the used-car market, where prices are rising. Demand and supply both supporting prices – people don’t want to use public transport but there is also a shortage of new vehicles due to a lack of semiconductors and low steel inventories.
It isn’t just carmakers, companies that haven’t been able to rise prices for years suddenly find they have pricing power; even a can of Dulux paint costs around 10% more than it did a year ago. Some traditionally cyclical sectors whose products had been regarded as being largely commoditised are now enjoying pricing power. That won’t last for ever – but we’re profiting from it while we can.
We still hold quite a lot in cyclicals compared to our history, but have been reducing the weighting over the last six months. We are likely to continue to reduce as many valuations are ‘up with events’. On financials, we have reduced our exposure to interest rates. Despite rising prices, Treasury yields are proving incredibly sticky. That’s not good news for rate-sensitive financials (such as European and US banks). We’ve deliberately reduced the correlation of our portfolio to 10-year US Treasury yield. Instead, we look elsewhere in the financials sector, to consumer finance companies, for example, and asset managers, which are less sensitive to rates.
Our exposure to so-called ‘bond proxies’ is likely to rise from here. This is primarily because lot of ‘mobility infrastructure’ (airports and tollroads) is becoming investable once again as economies reopen and offer dividend yields of 5-6%.
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