BNY Mellon Investment Management: Why income continues to shine

For years loose monetary policy meant companies could spend cash on essentially what they liked. But the return of higher interest rates has changed that, creating an environment in which income stocks shine, says Newton global income portfolio manager Jon Bell.

The transition from an era of “free” money to one of higher interest rates in which companies must pay more to borrow money has heralded “the end of extravagance”, says Newton global income portfolio manager Jon Bell. This shift has instilled a better sense of capital discipline, which he thinks should benefit income stocks.

According to Bell, certain capital distribution models became distorted since the global financial crisis. Since then, he argues rather than giving cash back to shareholders, some companies have been spending on extravagant and unnecessary employee perks.

Perhaps the most ridiculous example of this corporate largesse, he adds, is a Puppytorium which, as the name suggests, is a room in which employees can pet puppies to relax and destress.

What is a shareholder?

Bell thinks it is time for asset managers and equity owners to remind themselves of what exactly it means to be a shareholder – and challenge companies on this. “You are an owner of the business, you own the cashflows,” he states. “It is time for companies to treat their owners – their shareholders – with more respect. Stop wasting money and give it back to shareholders. The message is simple: show us the money.”

This dynamic is illustrated by the fact the payout ratio of the MSCI All Company World Index has fallen from about 54% in March 2017 to 48% in March 2023. Meanwhile, however, companies’ operating margins have expanded in most regions. Even in Japan these margins have moved from 4% in 2005 to just over 6% in 2022 (see charts below).

But some industries are not listening. Bell says since 2006 the operating cashflow of the four largest tech companies – Apple, Amazon, Alphabet and Microsoft – has increased more than 10x to around US$350bn, equivalent to the GDP of Pakistan. Yet less than 10% of that cashflow, equivalent to the GDP of Cyprus, is being returned to shareholders, he points out.

In contrast, some industries have been good at rewarding shareholders, adds Bell. In the pharmaceutical industry some large firms have optimised their business models so that the risky early-stage research and development (R&D) process is being left to smaller biotech players. The big pharma companies get involved once the product is closer to commercialisation.

“That has allowed payout ratios to increase and transitioned the business models of large pharma companies to be more predictable and stable,” says Bell. “But they still trade on lower multiples than consumer products counterparts and to us that is an opportunity.”

Another sector Bell highlights is utilities. He notes at the start of projects, such as building a gas pipeline, the upfront capital expenditure is high but once the asset is operational it is low cost to run and generates cash which can be given back to shareholders.

Bell says another attractive quality to utilities companies is they exhibit capital discipline by seeking shareholder approval before embarking on new projects or acquisitions. “That capital discipline provides a predictable and reliable business,” he says.

Compounding

Bell argues in a world where returns are likely to be lower on the back of slower economic growth, the dividend component of a portfolio’s return becomes more important.

He notes if someone had invested US$1 in the US stock market in 1900 and relied solely on capital appreciation, by the end of 2019 that US$1 would be worth around US$500. But if they had reinvested the dividends, it would have been worth US$73,000[1]. “It is the compounding of dividends that drives long-term return,” he adds.

Bell is also keen to dispel the myth that income stocks are uninspiring in terms of total returns. He notes how between 1928 and 2019 portfolios comprising high dividend paying stocks outperformed those made up of low dividend paying stocks[2]. “High yielding companies are actually very exciting,” he adds.

After bubbles

On average dividends have accounted for 59.4% of the total return from the S&P 500, adds Bell. There were two decades – 1990s and 2010s – in which this component was much lower. But he says these two decades were arguably growth stock bubbles, noting when bubbles burst, dividends are an important part of the total return (see chart below).

This decade (2020s) has started with dividends making a low contribution to the total return, Bell notes. This was due to cuts and suspensions to shareholder pay-outs during the pandemic and low interest rates and quantitative easing driving speculation in markets, says Bell. He adds 2022 was a better year for income stocks and so far in 2023, leadership in equity markets has been driven by excitement around artificial intelligence.

But Bell also notes during the 1970s when inflation was last a significant feature in markets, almost 80% of the return came from dividends. “It is our view when we get to 2030, we will look back on a decade in which dividends have once again been a large percentage of total returns,” he says.

Important Information

For Professional Clients only. Any views and opinions are those of the investment manager, unless otherwise noted. This is not investment research or a research recommendation for regulatory purposes.

For further information visit the BNY Mellon Investment Management website. http://www.bnymellonim.com