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Equity Perspectives

Vincent McBride, Lord Abbett Partner & Director, and Harold Sharon, Partner, International Strategist, answer questions about how high dividend yields overseas and a rigorous valuation approach can increase the potential for strong total returns. 

Q. Why are dividends such an important part of your investment strategy?
A.
Many investors focus largely on share price movements and market momentum instead of dividends—not realizing the extent to which long-run returns have been influenced by dividends that are reinvested. In fact, reinvested dividends account for at least 40–60% of total return over any significant time period [see Chart 1], according to a study conducted by London Business School professors Elroy Dimson, Paul Marsh, and Mike Staunton.1 Of course, dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

Chart 1. Long-Term Returns Have Been Largely Driven by Reinvested Dividends
Impact of reinvested dividends on cumulative U.S. and U.K. equity local-currency returns, 1900–2008

Source: Elroy Dimson, Paul Marsh, and Mike Staunton, “The Triumph of the Optimists,” Credit Suisse, 2009.
Past performance is no guarantee of future results. 

 

This chart shows the difference in terminal wealth arising from reinvested income can be very large. The dark green line shows the total return from a $1 investment in U.S. equities in 1900 with all dividend income reinvested, would have grown by 582 times by 2009. The gray line shows the real return of a similar $1 investment in a trust fund that paid out all its income, rather than reinvesting dividends, would have grown by just six times over the same period. The remaining two lines show the equivalent figures for the United Kingdom. Thus, the longer the investment horizon, the more important is dividend income.  

Q. How would you characterize the opportunities for dividend investors overseas?
A.
Dividend yields2 have long been significantly higher in many overseas markets than they are in the United States and across almost all sectors —and selecting markets by the highest yields historically has led to significant long-term returns [see Table 1 and Charts 2 and 3].

 

Table 1.  International Dividend Yields Are Higher Than U.S. Dividend Yields in Most Sectors

Source: Bloomberg and FactSet. Data as of April 23, 2015.
*Screen represents the top 20%, by dividend yield, of the universe of non-US companies with a market cap greater than $1.5 billion and average daily volume greater than three million (approximately 491 companies). Screening criteria is based on the team’s investment process, which first narrows its eligible universe of securities by identifying non-U.S. companies with market caps greater than $1.5 billion and trading volume greater than three million.
Total yield numbers in each universe referenced above reflect an average of the dividend yields of each company weighted by market cap. 
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. 
Past performance is no guarantee of future results. 

 

Chart 2. International Dividend Payout Ratios Have Historically Outpaced Those in the United States
Dividend payout ratio of the MSCI ACWI ex U.S. Index versus the S&P 500 Index3 (12/31/1995–12/31/2014)

Source: Bank of America. Data as of December 31, 2014. 
Dividends are not guaranteed and may be increased, decreased, or suspended altogether. at the discretion of the issuing company.
Charts 1 and 2 are for illustrative purposes only and do not represent the performance of any Lord Abbett mutual fund or product, or any specific investment. Information in charts is the most recent data available. 
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Foreign securities generally pose greater risks than domestic securities, including greater price fluctuations and higher transaction costs. Foreign investments also may be affected by changes in currency rates or currency controls. With respect to certain foreign countries, there is a possibility of nationalization, expropriation or confiscatory taxation, imposition of withholding or other taxes, and political or social instability that could affect investments in those countries.
A dividend payout ratio refers to the fraction of net income a firm pays to its stockholders in dividends.

 

Chart 3. Selecting Markets by the Highest Dividend Yield Has, Historically, Led to Significant Long-Term Returns 

Source: Elroy Dimson, Paul Marsh, and Mike Staunton, “The Triumph of the Optimists,” Credit Suisse, 2009.
Past performance is no guarantee of future results.
The chart above reflects a study of the long-term annual returns of 19 major equity markets, rebalanced annually, arranged into five quintiles based on the historical dividend yields of companies within each respective market. The two categories depicted above represent the lowest-yielding quintile and highest-yielding quintile of the five. 
The data represented in this chart are for illustrative purposes only and are not intended to predict or depict the performance of any Lord Abbett mutual fund or product, or any specific investment.  
Dividends are not guaranteed and may be raised, lowered, or suspended altogether at the discretion of the issuing company.

 

Q. Please describe your investment goal and portfolio-selection process.
A.
The International Dividend Income Fund seeks to outperform its benchmark, the MSCI All Country World Ex-U.S. Value Index with Net Dividends,3 over a full market cycle. Our portfolio selection process begins with a potential universe of more than 2,100 companies, all non-U.S. firms, each with a market cap greater than US$1.5 billion, and average daily volume greater than three million shares. Using a bottom-up, value-equity approach, we focus on the top high dividend-yielding companies with an emphasis on dividend sustainability, stable growth/high free cash flow, and significant potential for capital appreciation. The effective universe of high-yielding companies, at any point in time, is approximately 491 (that is, the top 20%).

Q. Ten-year eurozone sovereign bond yields have declined by 80–150 basis points during the first 11 months of 2014. U.K. and Australian 10-year sovereign bond yields are down 60 basis points and 90 basis points, respectively, over the same time period. How have international equity dividend yields been affected?
A.
The investable universe has not changed much over that time period. There are 748 companies worldwide with a market cap greater than $1.5 billion and a current dividend yield greater than 4%. What some investors may not realize, though, is that 77% of the companies are overseas, with 25% of the total in emerging market companies, according to FactSet data as of November 15, 2014.

There have been areas of relative outperformance: REITs [real estate investment trusts] in the Asia/Pacific region, select European utilities, and other infrastructure-related companies with high, stable dividends.  Overall, we are still able to select and invest in a broad range of companies with above-average dividends. Most international equity indexes are flat to down year to date. As Chart 4 shows, most major equity markets worldwide sport current dividend yields in excess of their 10-year government bond yields.

 

Chart 4. In Some Countries, Dividend Yields* Have Surpassed Government Bond Yields
Dividend Yields vs. 10-Year Government Bond Yields (%)

 

Source: Bloomberg. Data as of 4/21/2015.
*Dividends as represented by the major indexes of the aforementioned countries: Australia (S&P/ASX 200 Index; Spain (Ibex 35); United Kingdom (FTSE 100); France (CAC 40); Hong Kong (Hang Seng); United States (S&P 500); and Japan (Nikkei 225). 
Past performance is no guarantee of future results.
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment.

 

Q. Where do you find the best opportunities?
A.
We find good investment ideas across a number of different areas within our potential investment universe. One anomalous area today is where we find healthy companies with a current dividend yield higher than their own corporate bond yield. These companies are spread across a broad range of sectors, including telcos, health care, consumer staples, financials, and energy. As of September 30, 2014, there were 64 stocks in the Fund that also have corporate bonds outstanding. Fifty-nine of them had dividend yields greater than their corporate bond yields. On average, the dividend yields are 235 basis points higher than their corporate bonds—and 309 basis points greater than their countries’ 10-year sovereign bond, according to Bloomberg and FactSet.

Q. How do emerging markets factor in this strategy?
A. 
Emerging markets have been a substantial contributor to our returns over the past five years. Many investors are surprised by the number of high-dividend-yielding companies that exist in the emerging market universe. As of November 17, 2014, approximately 11% of the portfolio was invested in emerging economies, across many markets, including Turkey, Hong Kong/China, Brazil, Mexico, South Korea, and Taiwan.

Q. Which investor misperceptions about the investment strategy did you have to overcome?
A
. The most common misperception is the idea that we are just “clipping dividends” from higher dividend-yielding stocks. This is not our investment strategy; we are investing in undervalued stocks that also carry relatively high dividend yields. And we have the flexibility to invest across small, mid, and large cap companies as well as in emerging markets and developed markets for optimal diversification. We believe investors should benefit in two ways: the compounding of reinvested dividends and the appreciation of the undervalued stock.

Q. How would you compare the International Dividend Income Fund to other funds in this area?
A.
 The first major difference is philosophical. We understand that reinvested dividends have, historically, accounted for 40–60% of the total return of any major global equity markets over any 10-year time period since 1900. Armed with this information, we believe that our strategy of high dividend yield/low valuation sets us up to deliver competitive total returns.

Our strategy of international dividend yield/low valuation is different from many international value investment strategies because they tend to focus on distressed/low-valuation companies that are no longer able to pay a dividend.     

Q. What are the key risks with the strategy?
A.
The key risks in a high dividend-yield equity strategy are primarily twofold: the first risk is associated with investing in bad or failing business models, where the high dividend yield is not sustainable and is ultimately cut or eliminated. The second primary risk is investing in high-yield equities that are fully valued or overvalued. We want to target companies that can deliver capital appreciation and dividend income. Given these risks, we don’t advise using passive vehicles/ETFs [exchange-traded funds] for a high dividend-equity strategy.

Q. How do you address the risk of dividend cuts?
A.
Dividend cuts are cyclical, and generally ebb and flow with company/industry fundamentals and the global economy. We did see a significant number of dividend cuts and eliminations in 2009, but have not experienced many during the last four years as the global economy has improved. Notable dividend cuts have occurred across the European telecom and banking sectors over the past three years. Historically, dividends are much more stable versus earnings; dividends normally are only one-quarter as volatile as earnings. [See Chart 57] In fact, the overall strategy has shown positive dividend growth over the past one- and three-year periods. We believe that rigorous bottom-up analysis and a focus on cash flow can yield well-informed opinions about the sustainability of dividends. In other words, active managers should be better able than passive managers to detect companies at risk of cutting their dividends.

 

Chart 5. European Dividends Have Been Only One-Fourth as Volatile as Earnings
How dividends have fallen in relation to earnings in past recessions

Source: UBS estimates and European Market Map.
TMT refers to the speculative bubble in information technology, media, and telecommunications stocks that peaked in 2000.

 

Q. Please describe the discipline that goes into risk management.
A. 
Risk management is an integral part of the portfolio construction process, and we consider risk at all stages of the process. Particularly important to our ability to add value is the continual process of understanding and controlling the level of risk in the portfolio.

In addition to the risk analysis performed by the portfolio managers, Alec Crawford, Lord Abbett Partner, Chief Risk Officer, leads the three-member Equity Risk Management team. Portfolio managers and the Equity Risk Management team meet regularly to review risk reports and discuss current exposures, ensuring that such exposures are intended. The Equity Risk Management team focuses on identifying risks from a top-down perspective to ensure our managers understand all the risks they are taking (e.g., stock, sector, and macroeconomic) and to mitigate those that may be unintended. Ultimately, the goal of our risk management procedures is to ensure portfolio risk is deliberate and understood and that the investment strategy maximizes the positive impact of security and sector selection from our portfolio management team.

Q. The bottom line?
A. 
Dividends matter. Foreign companies historically have had lower valuations, higher payout ratios, and persistently higher yields. The current environment is robust: it is possible to build a portfolio of companies internationally yielding more than 5% without sacrificing quality or diversification.

 

Elroy Dimson, Paul Marsh, and Mike Staunton, “The Triumph of the Optimists,” Credit Suisse, 2009.
Dividend yield is equal to the dividend divided by the stock price. Dividend yield is one measure of a stock’s value. A high dividend yield may indicate that a stock is relatively inexpensive.
The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
The MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI Ex-U.S. Index with Gross Dividends approximates the maximum possible dividend reinvestment. The amount reinvested is the entire dividend distributed to individuals resident in the country of the company, but does not include tax credits.  MSCI uses withholding tax rates applicable to Luxembourg holding companies, as Luxembourg applies the highest rates.
Beta is a measure of volatility relative to the market. A stock or portfolio that fluctuates more than the market has a beta above 1.0. A stock or portfolio that fluctuates less than the market has a beta less than 1.0.
Price-to-earnings ratio is the ratio of the share price to the earnings per share for the last 12 months. This ratio is one measure of valuation.
Karen Olney, CFA, Nick Nelson, and Andras Nagy, “Europe’s High-Quality Dividends,” UBS Global Research, October 17, 2014.

 

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