Identifying yields capable of growth

The payouts indicate healthy, free cashflow: the key input into a company’s discounted valuation, and the ultimate financial purpose of any equity investment. 

Regular cash payments are easy to understand compared with the esoteric world of share prices, which can meander in response to an enormous array of considerations – some of which are logical, some not.

The market equates dividends with financial strength. Dividend-paying companies provide an income stream capable of meeting the owners’ liabilities. In a world of abnormally low interest rates, where yield is so hard to come by, this is an ever more useful financial trait.

It is true that over the long term dividends are a key determinant of equity returns. In the UK, for instance, more than four-fifths of the equity market’s real return since 1900 has come from reinvested dividends. 

In the US since 1927, higher-yielding companies have outperformed zero-yielding stocks by 2.8 per cent a year, an enormous quantum when compounded over a long period. 

By focusing on yield, investors are therefore fishing in the right pond. Not only do dividends compound at a healthy rate over the long term, by omitting stocks without them investors also avoid the worst speculative excesses of the markets. For example, very few dotcom companies paid any dividends.

But there is need for caution. While a high dividend yield can be the sign of a solid company throwing off more cash than it can use, a figure that is too high should give pause for thought. The maxim that ‘if something appears too good to be true, it probably is’ has enormous validity in the world of investment.

Caveat emptor. Investors are justifiably suspicious of high-yield bonds – which are often labelled ‘junk’ for a reason – but are attracted to the supposed safety of high-income equities. This is an inconsistent and illogical reaction. After all, dividends are only paid to shareholders after bondholders have received their interest.

A very high yield can be a sign that the company is under financial stress, and may be forced to cut its dividend – generally an atrocious outcome for the owner. 

Furthermore, when you dissect the equity market, some of the highest-yielding sectors are those normally associated with the highest risk, or the lowest quality.

Telecoms, financials, oils and utilities are some of the most verdant areas of the market for yield, yet each of these sectors faces some profound issues. Telecoms are capital hungry, heavily regulated businesses, with a poor record of value creation. 

Banks are highly levered and have an unfortunate habit of periodically flirting with bankruptcy. 

Oil companies not only depend for their prosperity on a volatile and unpredictable commodity price, they also face huge operational risks – think about the bill for BP’s Macondo disaster, and longer term the risk of decarbonisation. Ditto utilities, whose coal and gas-powered assets may be of little relevance in a world pivoting to renewable energy.

It is therefore critical that investors individually assess the resilience of each potential investee company to ensure the dividend is secure in perpetuity and, preferably, able to grow on a compounding basis.

Many factors are relevant, from simple cashflow coverage ratios, to the underlying strength of the balance sheet: a qualitative assessment of the competitive environment, and an awareness of the precise cyclicality of the business. 

Environmental, social and governance considerations are also crucial, as well as a keen understanding of the relevant regulatory backdrop.

Above all, investors must always be mindful of the truism that equities are long-term assets, and that the bulk of their value is typically derived from cashflows expected to be generated well into the future.

Absolute risk to capital must be as low as is practical; downside risk is as important as upside participation. An income investor’s goal, therefore, is not just to find high dividend yields, but more importantly to find sustainable yields that are capable of growth. 

Julian Bishop is global equities analyst at Sarasin & Partners