In a recent presentation entitled ‘Navigating Uncertainty’, Lazard Global Equity Income manager Pat Ryan said high-yielding equities are a pretty good place to be invested given the low valuation environment.
The all-too-familiar fragility of the global recovery, the high levels of inflation across the Middle East and other emerging economies, and high commodities prices and wage pressures, particularly in those countries experiencing civil unrest, make for a highly uncertain current environment.
That said, with fairly robust balance sheets and cash generation, and companies generally better managed than they were before the financial downturn, Ryan believes there are several positives in the current income-seeking investment environment. Confidence is returning, as signalled not only by companies’ resumption M&A activity as the bond market opens up but also by retail investors moving assets from the perceived safety of bonds to equities. And though this confidence remains highly fragile, Ryan believes the outlook for equity dividends is “pretty solid.”
Dividends in an Inflationary Environment
Of course inflation, or deflation, or even stagflation, remain a significant concern and the bane of income-seeking investors. But Ryan says that equity valuations are fairly resilient in a range of inflationary environments. “No financial instruments like inflation,” he says, “but equities tend to outperform bonds in an inflationary environment so if we do see rising inflation, high-yielding equities are a good place to be.”
Ryan adds that not only are dividends historically resilient and offer low-risk returns—while over 70% of the MSCI World Index’s total returns (GBP) over the 41 years from January 1970 to December 2010 came from price returns at a standard deviation of 15.7, almost 30% came from dividend returns with volatility of just 0.4—but in real terms dividend growth tends to keep up with inflation. Highlighting UK data tracking nominal and real dividend growth since 1932, Ryan showed that annual dividend growth has historically risen with or faster than inflation, event in an environment of sharply rising inflation.
Of course we mustn’t get carried away; the economic outlook is still extremely tentative, and risks remain both to the upside and downside, but Ryan is pretty comfortable that the dividend outlook is positive across a wide range of economic outcomes. A raft of companies cut or suspended their dividend payments between 2008 and 2010 but these dividends have started to be recovered and asked about the risk of a ‘double dip’ in dividend policy, Ryan notes that if a company is forced to cut its dividend its going to cut it enough to cover “if the 100-year-flood happens again”, and those companies that felt their dividend was vulnerable have already made changes.
Go Global for Income Diversification
Given this optimistic outlook, where is Lazard’s global equity income team looking for yield? Ryan highlights the importance of going global when seeking equity income and says the ability to shift assets across geographic regions is a key driver. Emerging markets equity, for example, more commonly attractive for its growth potential, in addition to enhancing returns also increase diversification potential and enhance yield, Ryan says. There are some attractive opportunities for equity income in unusual places, such as sectors that aren’t traditionally known for their dividend yield, like technology and miners, and economies that might be deemed no-go areas, such as Greece.
By country—the old, stale way of looking at the investment world, Ryan notes—the Lazard Global Equity Income portfolio has its greatest proportion of holdings in North America (29.1% of the portfolio as at December 31, 2010) but is substantially underweight versus the MSCI All Countries World Index. Conversely, 26.4% is invested in Europe ex-UK, a notable overweight that has come about due to the attractive valuations of Europe stock. Emerging Asia Pacific, Latin America, Asia Pacific ex-Japan, and the UK make up 10.5%, 7.3%, 7.2% and 6.5% of the portfolio, respectively.
Financials In Favour, Utilities and Healthcare Out
What’s perhaps of more interest is the sector split of the portfolio, where 23.8% is in financials, with roughly a third of that in insurance. Indeed, Provident Financial was one of the fund’s primary buys in the fourth quarter of 2010. Elsewhere in the sector, Lazard sees opportunities in emerging banks, in Brazil and China, for example, where the credit environment is very different from in the developed markets, US real estate investment trusts, and stock exchanges such as NYSE Euronext and Bolsas y Mercardos Espanoles.
Telecoms are another key holding for attractive dividend yield (13.6%), followed by energy (10.8%), information technology (9.8%) and consumer discretionary (9.7%). Interestingly, the smallest proportions of assets are allocated to two sectors traditionally known for their dividend offering: utilities and health care. The former is overpriced, Ryan says, while the latter’s problems are long-term. “More money’s being spent on research and less drugs are actually coming out,” Ryan says in explaining why they’re not fans of healthcare. Having said that, Pfizer is a favourite within the sector due to its CEO’s aggressive plans for the company.
In the tech sector, the attractiveness relates to the fact that many players don’t have any debt, they’re cash-generative and cyclical, so stand to improve as the world economy improves, Ryan says. Another of the fund’s primary buys recently was CRH, which Ryan says was unfairly hurt by where it’s domiciled despite 98% of its revenue being generated outside of Ireland.
Principles Behind the Hunt for Equity Income
The principles behind picking companies for dividend are fairly straightforward: Ryan looks for those that are more cash generative, higher returning, less indebted and whose dividends were more resilient through the recession. Cash-generative companies that have been laggards or hit a soft spot are worth a look for their high yield and solid fundamentals.
All in, it’s quality companies that are cash-generative and enjoy strong balance sheets that provide interesting dividend opportunities, and being able to tune out the market noise and focus on finding these characteristic is a key principle for income-seeking investors.
