Invesco: Global Equity Income Strategies... When will they stop underperforming the broader market?

• Global Equity Income orientated strategies have been underperforming the wider market for some years now. It certainly feels like a long time ago since an avalanche of research was singing the praises of high yield investing
• Market leadership has been dominated by a narrow range of growth orientated stocks. Growth has been 'scarce' and therefore highly valued, and its longer 'duration' has benefited from record low bond yields. Most obvious has been the run up in certain technology names.
• Are market conditions now favourable for a rotation towards companies with strong balance sheets and higher dividend yields?  We think they are, rising interest rates have often been catalysts for change in market leadership.

With performance for Global Equity Income strategies lagging the MSCI World index for five years now, we listen with interest when we hear the suggestion that income-focused strategies are dead. This is based on the summation that we are now in an era where the search for earnings growth at almost any price is the dominant strategy, with the conclusion that ‘this time it is different’. It’s worth noting that we last heard similar comments back in 1999.

This contradicts long-term trends noted since the 1970s that income-orientated equity strategies have, over the long run, outperformed the broader market. We note that this current period of underperformance is by no means unique, however, with 1998-00 showing much sharper underperformance from income-orientated equity strategies (see Fig 1).

Why have Global Equity Income funds underperformed?

The short answer is the outperformance of growth stocks particularly since 2010/11 (see Figure 2). In our view this outperformance has been driven by two key factors, firstly the unconventional monetary policies practised by central banks around the world. These have driven interest rates close to zero and inflated the value of so called ‘long duration’ assets where the bulk of value is encompassed by the terminal value. In other words the cost of capital for many companies has become artificially low. Secondly, despite this, global economic growth has remained sluggish, encouraging investor crowding in those stocks and sectors with reliable earnings growth. The price paid for that growth has been less a concern in a world with close to zero interest rates.

At present, in our view, ‘growth’ in its purest form is represented by technology/disrupting stocks such as Facebook, Amazon and Netflix, the so called FAANG stocks. They pay no dividends, nor are they likely to, hence they are unlikely to form a significant part of an income investor’s portfolio. However, over the last five years (to 28 June 2018) as a group they have outperformed the MSCI World index by close to 70%. Yet as a group they currently represent around 8% of the benchmark and yield in aggregate around 0.6%. Not owning them would have been around a 6% drag on performance over five years. Of course it has not just been technology, ‘predictably-growing’ stocks exhibiting low volatility have tended to outperform too, particularly in the consumer and healthcare sectors.

Let us be clear, whilst in our view ‘equity income orientated’ and ‘value’ investing are not twins, they are least first cousins. They share some similar attributes such as a focus on free cash generation and above average dividends. They differ in others, being less interested in metrics such as net asset value and normalised earnings. It is therefore not a surprise to see ‘equity income orientated’ funds lagging a market where investors have not focussed on the price they are paying, and where they have prized low volatility and earnings growth above all other attributes.

When will market conditions be favourable for Global Equity Income funds?

While we cannot call the exact timing we believe better relative performance for income-orientated strategies may be close.

• Rising bond yields tend to be negative for long duration, high growth assets. Most of the value in rapidly growing companies is in cash flows many years in the future, as bond yield rise the present value of those cash flows fall. Furthermore, as the cost of money rises, so investors become less willing to tie up capital in low yielding assets (that includes gold!!).
• Any upward move in inflation serves to highlight the real rather than nominal nature of equity income compared to bonds.
• Recent well documented events have brought into question the sustainability of certain business models in the tech sector. However, we note the technology-driven correction in March, sparked by company-specific news from Facebook Inc and Nvidia Corp, has done little to dent tech sector performance in the short term.
• The valuation ‘elastic’ can only be stretched so far. We are approaching historic levels of divergence between growth and value stocks.
• Profit and risk dynamics of two key high dividend sectors are improving. Both financials and the energy sector have been through a number of difficult years. Whilst they have looked cheap for several years, only now are they regaining earnings momentum.

Invesco Perpetual Global Equity Income Fund

• It is not just about dividend income. Every stock in the portfolio we believe is undervalued and hence should over time outperform the benchmark MSCI World index. We seek to deliver an above average dividend yield which also grows slightly faster than the yield on the benchmark.
• We aim to invest in fundamentally attractive businesses with positive cash flow and strong balance sheets which minimises the risk of dividend cuts.
• The fund is constructed from the bottom up. We do not asset allocate to geographic regions or market sectors. Each holding is included for its own intrinsic attributes.
• Notwithstanding the above, the team ensures the portfolio is well diversified by region, sector and stock. Regular input from our risk team helps us to understand underlying portfolio characteristics and likely portfolio performance in different scenarios.
• The portfolio is quite focussed, with between 50-55 holdings.
• It is a team based approach. The team is led by Nick Mustoe, who is ultimately responsible for the portfolio, but the idea generation and analysis is done by the six regional managers. There is team ownership of all decisions and team members are rewarded on the performance of the whole portfolio, not on the stocks they personally proposed for the portfolio.
• The current yield to investors after withholding tax is around 3%.
• Figure 3 shows the exposure of our fund to various investment style ‘factors’. The bars indicate the range of our exposures in the five years to 31 May 2018. The dots are our current positioning. As you can see our exposure to a range of value factors (in blue) is at the highest level we have seen over the five-year period. This indicates to us the dichotomy in market valuations. Our fund, which normally has some bias to cheap cash generative companies, is more aggressively positioned than normal. This reflects the opportunities that we see present in the market.

How have we performed?

Versus our competitors in the IA Global Equity Income sector, the Invesco Perpetual Global Equity Fund has delivered significant outperformance over the last three years with similar levels of volatility (see Fig 4).

A patient approach

While we acknowledge that the very strong growth in profits in many large technology companies has justified some re-rating, we question whether in many cases this is now overdone. Furthermore, in our view, the growth in passive and smart beta products with their momentum-driven approaches has further boosted the prices of those assets and extenuated the divergence in performance between sectors.

We will continue to focus on identifying cash generative businesses and above average, growing dividends trading at attractive valuations. We do not know when such ‘traditional’ investment techniques focused on valuation will return to favour with the broader market and this can be arduous for both fund managers and clients alike. However, we know that the long-term results from this approach have been proven to be extremely attractive.

John Botham is Product Director, Global Equities at Invesco Perpetual.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange-rate fluctuations) and investors may not get back the full amount invested.

The fund may use derivatives (complex instruments) in an attempt to reduce the overall risk of its investments, reduce the costs of investing and/or generate additional capital or income, although this may not be achieved. The use of such complex instruments may result in greater fluctuations of the value of the fund. The Manager, however, will ensure that the use of derivatives within the fund does not materially alter the overall risk profile of the fund.

Important information

All information as at 30 June 2018 sourced from Invesco Perpetual unless otherwise stated.

The Historic Yield of the Invesco Perpetual Global Equity Income Fund reflects distributions declared over the past twelve months as a percentage of the mid-market price of the fund, as at the date shown. It does not include any entry charge and investors may be subject to tax on their distributions. The fund’s ongoing charge is charged to capital. This has the effect of increasing the distribution(s) for the year by the amount of the ongoing charge and constraining the fund’s capital performance to an equivalent extent.

Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.

This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.

For the most up to date information on our funds, please refer to the relevant fund and share class-specific Key Investor Information Documents, the Supplementary Information Document, the Annual or Interim Reports and the Prospectus, which are available using the contact details shown.