Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Alan Porter, Portfolio Manager, Securities Trust of Scotland, explains how equity income offers value in a low growth world.
In these times of economic uncertainty, global equities can still provide an ideal platform for investors searching for a steady and defined income.
That said, positive macroeconomic news has proven hard to find over the last few months. A fall in global equity markets, continued oil-price weakness and declines in global bond yields have reinforced my view that we remain in a fundamentally low-growth environment.
In these conditions, how do investors continue to find companies that can see through the short-term noise and continue to pay sustainable dividends?
Low Growth
The indications are that this period of low-growth will continue for some time. Real GDP growth in China, once in the double digits, is now officially at around 7% and is forecast to decline further over the next few years. Many believe though that the real figure is already closer to the 4-5% mark. The Chinese government has intervened to attempt a rebalancing of the economy, including the devaluation of the renminbi, but there are still substantial challenges ahead.
Among the advanced economies there is a similar picture with real GDP forecast for 2.1% in both 2015 and 2016.
While the US Federal Reserve said in September that economic activity in the US was expanding at a moderate pace, it held off on its anticipated interest-rate rise – stating that ‘global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term’.
Companies Reluctant to Spend Capex
Prolonged periods of low growth can present difficulties for income investors. One of the themes in the last couple of years has been caution from corporations on increasing capital expenditure. While this has been a key opportunity in the short term – as cash-rich companies are more willing to pay out dividends to shareholders – it is also a risk. In the longer term, a lack of investment could damage the sustainability of these payouts and what we really need to see is companies investing more in their businesses.
Finding Attractive Prospects
As investors look for more predictable returns, companies with good self-help stories – where company management teams take decisive action to increase profit margins via internal changes – are potentially more attractive than cyclicals, whose revenues are more sensitive to market peaks and downturns, or growth companies where expectations may be too optimistic.
Another area of interest is companies where there is dividend recovery potential, such as US and European banks. In Europe, when quantitative easing (QE) was introduced earlier this year, it had the effect of repairing balance sheets for companies in the financial sector, at least temporarily. European Central Bank President Mario Draghi has said further easing measures could follow in the future – although this remains to see whether this had a similar impact.
Finding Good Value
Finding value is harder in a market that has seen strong performance since the depths of the global financial crisis. In my view, many defensive stocks – which provide stable returns through the economic cycle – look expensive. Energy and materials companies may appear cheap due to low expectations for commodity prices – particularly oil and iron ore – but the question for investors is, when will be the right time to increase exposure to these sectors – if at all? Nevertheless, there are plenty of interesting opportunities to be found outside of these areas, particularly in the financial and industrial sectors.
Positives for the Future
Overall, as an income investor I remain cautiously optimistic about the long-term picture. The US and UK economies are seeing tentative signs of improvement and the further we are along from the global financial crisis I would expect to see companies more willing to beginning investing in capital expenditure again.
In addition, depending on the pace of estimate reductions, valuations may start looking more attractive given recent market declines. Macroeconomic events have led to more uncertainty than earlier this year, but, compared with other asset classes and in terms of the relative yield they can provide, equities still remain an attractive prospect.
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