I’ve spent much of this morning digging around inside the latest edition of the seminal Global Income Investor report from last Thursday. Andrew Lapthorne’s team regularly update this report and it’s a treasure trove of useful data on long term investing trends.
It’s absolutely worth thinking through global equity income trends for one simple reason – as so many reports remind us, the lion’s share of long term returns from global equities, comes from dividends and their subsequent reinvestment. Depending on who you talk to – Lapthorne at SG, or Dimson, Marsh and Staunton via the Credit Suisse yearbook – anything between one third and 90% of long term (20 year plus) equity returns comes from the humble regular dividend cheque (helped by the more recent share buyback tender).
That should explain why dividends matter, but if we’re honest if you’re based outside the US, it should matter even more. The first chart below is from the SocGen report and shows that over the decade or so since the global financial crisis, returns for the MSCI World exc USA can be broken down into the dividend yield, valuation changes, and earnings growth. Using this measure for non US developed world markets, “EPS growth has been more anaemic and valuations have de-rated, and here the compounding dividend yield has pretty much been the only game in town; without dividends, investors would have made very little, if anything at all”.
But it would also be remiss of us to forget share buybacks, which are an especially large part of total returns to shareholders, especially in the US. The second chart shows the total distribution to shareholders (buybacks plus dividends) over the last 25 years. That distribution has increased from 20% in 1995 to a peak of around 45%. Already the payout was declining and we are likely to see an even more rapid decline in 2020. I’d also wager that share buybacks will vanish this year (which is good news in my book) and in fact turn negative – as businesses issue fresh capital to stay alive. I’d wager we could see the total distribution rate will fall to less than 15% before we are finished.
Cue the Covid 19 crisis and we have the perfect storm, especially for non US stocks. Earnings have fallen off a cliff and taken with them dividends. Futures traders are now expecting a 50% decline in 2020 dividends in Europe versus a 20% decline in the US. 20% of Stoxx 50 and FTSE 100 businesses have already cancelled their payouts. Looking at the first four months of 2020 versus 2019 data from Bloomberg reveals that Stoxx 50 stocks have already cut their dividends by 39% FTSE 100 equivalent numbers are -17%). But looking at forward looking data comparing May 2020 with May 2021, the decline in the Eurozone expands to a stonking 57% decline, helped along with Eurozone banking dividends vanishing overnight.
These dividend cuts are huge although not entirely unprecedented. But in truth equity income strategies were already in trouble even before Covid came along. 2019 was not a great year for dividend focused investors.
The rot had set in much earlier as the world of equities divided into three camps. The first was growth stocks with no dividends and oodles of opportunity. The second camp comprised quality stocks with a great balance sheet and skimpy dividend payouts – usually well below a 4% yield. The last category was a motley assortment of value stocks and high yielders with weaker balance sheets, higher leverage, great vulnerability to cyclical themes and in many cases a higher yield.
The message from Lapthorne’s team at SocGen was always simple. Ignore the obviously over generous yielding stocks (more than 4%) and concentrate on the strength of the balance sheet (using the Merton distance to default measure). The challenge was finding quality stocks that both paid a decent dividend yield and boasted decent balance sheets. According to the SG analysis up to 2019, just over 1 out of 10 strong balance sheet stocks had a 4% dividend yield or more. What was sitting inside many equity income portfolios by contrast were vulnerable businesses with weak balance sheets and big cyclical risk (oil and banks). These sectors are now in the eye of the storm.
So, what does Lapthorne think we should concentrate on now? A number of messages come through his latest analysis. The first is that the number of stocks which pass his latest quality and income tests has collapsed and one measure he had only 26 names globally which qualified, versus 89 at the peak of the global financial crisis. But of those stocks that do qualify, many more now seem to be in the consumer goods space while in geographical terms Asia is becoming more and more important, and especially Japan which in his models now has the biggest ever allocation, although to be fair four UK large caps do pass the test. So, if you’re thinking equity income is still a defensive strategy, make sure you are globally diversified with an ever greater exposure to Japan and Asia.