Themes, ESG, income and dividend growth: The key to dividend sustainability

All of the stocks that the fund invests in have to be growing their dividends. We implement a barbell strategy to construct a portfolio that can achieve high and growing dividends, with capital growth.

At the same time, we are very aware than Income investors also need a healthy stream of income in the current period, not just promises of dividend growth. Therefore, as a starting point, all stocks that enter the portfolio must generate a forward yield of at least 2%, whilst at the portfolio level, the aggregate dividend yield needs to be at least 1.25 times the MSCI All Country World Index. We then look for a balance of companies with higher yields that are growing dividends (“Income with Growth”), alongside firms with lower yields but with the potential for much higher dividend growth (“Growth with Income”).

An example of an “Income with Growth” name would be CME, which offers a yield of 3.2% at the moment, and where dividend growth is expected to be 3%[1]. CME sits within our Real estate and Infrastructure theme, and reflects a subset of that related to Financial Infrastructure. CME is one of the leading global financial exchanges and has a quasi-monopoly in US interest rate futures trading.

An example of “Growth with Income” would be Tokyo Electron, which has yield of 2.2% but which offers dividend growth of 13.5%[2]. Tokyo Electron sits within our Explosion of Data theme. The company manufactures Semiconductor manufacturing equipment, and is currently benefitting from supply shortages across the Semi space, which leads to manufacturers needing to increase manufacturing capacity.

This blended approach positions the fund to benefit from attractive levels of yield combined with sustainable growth in dividends, and also enables it to participate in capital appreciation.

Our approach is then augmented by selecting companies with stronger ESG credentials. We have pursued an ESG approach to income investing since the launch of the fund in and our long-term track record shows that ESG complements our return profile. In addition to leveraging our dedicated Sustainable Responsible Investment team, John Kisenyi joined the Global Equity team in 2020, leading engagement with the management of the companies that we are selecting for the Fund’s portfolio. The Fund currently has a Morningstar 5 globe sustainable rating[3].

[1] Morningstar as at June 2021
[2] Bloomberg, June 2021
[3] Bloomberg, June 2021
[4] Morningstar as at June 2021

Thematic approach to drive dividends

We invest in companies which are exposed to secular themes, which we believe will ensure the sustainability of earnings and therefore dividend growth.

We currently invest in nine themes, and use them as a filter within our investment approach, and multiple sub-themes beneath them. The common feature between the themes is  innovation and business disruption. The themes focus the way we go about finding opportunities in leading companies that will derive additional tailwinds from these themes to deliver topline growth. We believe that this is key to generating sustainable, strong cash flow and dividend yield, by tapping into long-term sustainable demand from consumers or industries. Where companies have exposure to these themes, we believe their growth rates estimated by the market will prove to be too low, and we have consistently shown this over time

Leadership is key to dividend growth and consistency

We invest in leaders within our nine themes – leadership enables them to capitalise on the thematic tailwind that they have. In the Mirabaud – Sustainable High Dividend Fund, we tend to invest in companies which are in a slightly later stage in their lifecycle, where growth is still very attractive but where they have already sunk the expansionary capex and which are therefore highly cash generative. This cash flow can therefore be used to return capital back to shareholders through dividends. Usually, there are investment grade-rated companies, which enjoy high free cash flow yields and have strong moats and strong balance sheets. Other attributes of leadership also include management and technology leadership, and more importantly, we are careful to make sure that a company and its management has the capability to capture these tailwinds.

We are also seeking to build a portfolio where dividend growth is expanding faster than global GDP.

2020: A challenge for income investors

2020 was a tough year for income investors, and the MSCI All Countries World high dividend Index (high dividend index) underperformed the MSCI All Countries World Index (broad market index) by a wide margin of -15%[1]. When we look at the source of returns for the high dividend index, yields remained somewhat flat. However, dividends per share at an index level fall 9% in 2020[2] because some companies suspended dividends given the macro backdrop as a result of the pandemic. Some companies held back paying dividends because of the uncertainty and some were prohibited from paying dividends by governments, such as in Europe.

In normal circumstances, we would expect a high yield index to have a lower beta than the overall market, and therefore outperform in down markets. However, with the threat of unpaid dividends, the market was far from normal, and the high dividend index performed in line with the broader market -33% versus -32% from the start of 2020 to the market lows on 23 March 2020. The high dividend index then lagged significantly during the recovery from the market lows, returning 50% versus 71% from the broader market to the end of 2020[3].

Against this backdrop, the Mirabaud - Sustainable High Dividend Fund was up 7.2% in 2020, ahead of the high dividend index, but below the broader market[4].

Strong value in income names

Given the significant performance comparisons between the two indices described above, this means the high dividend index ended 2020 trading at a significant discount to the broader market index, representing a 10-year low on a relative valuation basis. So far this year, leadership has changed and the high dividend index (up 13%) has outperformed the broader market index (up 12%)[5]. Some of this outperformance has been driven by Energy, Banks and Mining stocks as we go through the first stage of the recovery, and these are areas where we are typically underweight.

In the case of Energy and Mining we have zero weights from an ESG perspective. We have pursued an ESG approach to income investing since the launch of the fund in and our long-term track record shows that ESG complements our return profile. Income investors have historically hidden in high yielding names in areas like Tobacco, and Energy, and we do not believe this is good enough from an ESG perspective.

We do not invest in many banks, preferring structural growth names like Carlyle Group, the private equity firm, which again sits within our Real Estate and Infrastructure theme. The company has been taking share from banks in areas where this latter group have been struggling to operate due to over- regulation and capital constraints. We do have exposure to one bank in the portfolio, Sberbank, the leading Russian bank which generates industry leading Returns on Equity.

A balancing act

When these lower quality areas of the market lead, the Fund tends to lag because the portfolio is mainly weighted towards high quality, lower cyclicality and lower beta names. In market environments like this, we have to manage downside risk and stay true to our quality ethos. We do this by increasing the weighting of names in the Fund, which have a higher degree of cyclicalty, like Cummins, Union Pacific, and Tokyo Electron. All of these names are high quality names with thematic tailwinds, and they are ESG leaders, but they do operate in more cyclical areas.

We believe that in the time in the market where low quality, highly cyclical names lead, is coming to an end. As Purchasing Managers Indices peak and as economic growth decelerates from here on the back of tough year-on-year comparisons, we expect this environment to be consistent with a move from early cycle to mid-cycle. Against this backdrop, valuations on dividend names remain attractive relative to the broader market.

In the Mirabaud – Sustainable High Dividend Fund, we invest a combination of income and growth, and we believe that this sets the Fund up very well for the coming period when the cycle changes. Over the next 12 months, we expect the fund to grow earnings 15% versus the broad market, which is growing 9%[6]. We also believe we have twice as much potential for multiple expansion than the market, given the valuation discrepancy.

We believe valuations are attractive on dividend stocks, and on high quality stocks, and the market is moving away from early cycle names. These are positive attributes for the Fund, which invests in high quality franchises, with high growing dividends. Furthermore, we believe that the themes we invest in ensure the durability of that growth, and we believe that ESG is becoming more and more important in framing the investment case in managing future risks and opportunities.

Benchmark: MSCI All Countries World Index. 2021 figures to 31 May 2021. Past performance is not indicative or a guarantee of future returns.

[5] FE Analytics in US dollars for calendar 2020
[6] Bloomberg
[7] FE Analytics in US dollars from 31/12/2019 to 23/3/2020
[8] FE Analytics in US dollars from 23/3/2020 to 31/12/2020
[9] FE Analytic in US Dollars, N Dist USD share class for calendar 2020
[10] Mirabaud Asset Management

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