In a world of much lower yields from cash and government bonds, investors are increasingly looking for income from other asset classes. Hence, the rise…
in the yield of European equities yield above 5%, in contrast to government bond yields around 3% is rightly attracting investor attention. Yields have reached this level for both structural and cyclical reasons. For a number of years now, continental European companies have been delivering more attractive dividend yields than before. In fact, dividends have been a major contributor of total return. However, more recently the surge in yields has also reflected depressed valuations and fears of dividend cuts. The key question for investors looking for income from risk assets – equities as well as corporate bonds – needs to be whether the advertised yields will be delivered. The good news is that, indeed, many European companies will deliver outstanding dividend yields. For careful and selective investors, the current markets offer the opportunity to lock in high yields in attractively valued stocks. Particularly, defensive stocks stand out as they offer sustainably high yields at unusually attractive valuations.
Continental Europe on the rise
Looking at the structural trends for European dividends it is clear that traditionally much of Europe wasn’t known for attractive dividend yields, with the exception of the UK. However, continental European companies have come a long way in catching up with their British peers in the dividend stakes in recent years. They became more responsive to investor demands for income from the mid-1990s onwards. In this period, governments began to sell many of their equity stakes on to commercial investors who in turn began to push for more generous payouts. In fact, continental Europe showed strong dividend growth for the ten years prior to this recession. This pushed dividend yields to be about on a par with those available in the UK
One stock which encapsulates this shift in mindset among companies regarding dividends is KPN, the Dutch telecoms company. In the late 1990s, the partially state-owned company pursued among the most aggressive investment drives of any telecom stock which ended in sizeable destruction of shareholder value and several rescue capital increases. This sparked the complete privatisation of the company and change to a management which made shareholder return its top priority. As a result, KPN has returned more than its free cash flow every year in the form of dividends and share buy backs. It currently yields 6.6% and is buying back EUR1 billion of stock this year.
High dividends as well as capital growth The evidence on how dividends play into total return throws up fascinating facts. First, over the last 40 years, dividends have contributed 40% to real return in Europe. What is even more remarkable, stocks with high dividend yields offer the best capital performance over the long term. Intuitively, investors may think that there is a trade off between income and capital growth, but this is actually not the case. The data for a variety of regions, including Europe, show very clearly that stocks with higher dividend yields tend to outperform lower yielding stocks in capital terms (and thus obviously in total return) over the long run. The most likely explanation for this phenomenon is that dividend payments enforce discipline on company management, reducing the risk that cash is wasted on projects with low returns or on value-destroying acquisitions. For instance, the top 20% of companies as ranked by dividend yield delivered a capital return of 32% since 1990 versus 10% for the lowest yielding quintile of European companies. Share-price volatility is also lower for companies with high yields, so the total risk-adjusted return is even higher.
Dividends are not immune to the recession
This analysis benefits from hindsight as it looks at historical yields. To turn this analysis into an investment strategy, investors at any point in time clearly have to take a view on the risks to projected dividends of the stocks in their portfolio. This scrutiny is clearly more important now during what is probably the sharpest and most global recession on record. Earnings so far have fallen by 40% and are widely forecast to drop by 50- 60% from peak to trough during this downturn. Sizeable dividend cuts are to be expected against such a background. However, as in prior downturns, dividends are likely to fall by less, and somewhat later, than earnings. This is because firms let their payout ratio rise when earnings fall, to prevent extreme swings in dividend payments. In the early 2000s recession, European payout ratios rose from a cyclical low of 40% to 80- 90% at the bottom of the earnings trough. It is thus reasonable to expect dividends to fall by around 40% from peak to trough.
It all depends on the sector and stock
However, there will be a huge range of dividend performances between various sectors and stocks, which is why stock picking and sector selection are key for investors looking for income. The sectors which suffered the greatest dividends cuts by far at the start of this year were cyclical sectors, such as financials and industrials. Cyclical dividends for 2008 fell by 31% (financial dividends fell by 82% 2008 on 2007) against growth of 2% for defensive sectors, such as telecom and pharmaceuticals. Even though the worst of the financial storm looks to be abating during this spring, the earnings of cyclical companies will still be under intense pressure relative to those of defensive companies. Hence, you would expect this greater earnings and dividend risk to be reflected in cheaper valuations and higher dividend yields for cyclical companies. However, the stock market rally since the beginning of March has favoured high-beta stocks and stocks with poor earnings to such an extent that the valuation gap has reversed completely so that cyclicals are now more expensive than defensives (PE 2009 11.5x cyclicals versus 10.5x for defensives3). Moreover, cyclical sectors, which yielded nearly 7% in February, now just yield slightly more than 5% – the same as for defensive companies despite the far greater risk of dividend cuts amongst cyclicals (see Figure 2). For instance, the telecom sector which has sharply underperformed during the spring rally yields over 7% for this year (paid out early 2010). This sector enjoys low earnings and balance sheet risks. In fact, free cash flow yields are over 14%. Despite these attractive return characteristics, the sector is merely on 8.3 times 2010 profits, compared to 9.7 for the market. The pharma sector – similarly, left behind during the rally – unusually yields the same as the wider market at 4.8% for 2010 and offers decent and reliable dividend growth. Yet, the sector only trades on the same multiple as the market, and some names stand out particularly for the quality of their franchise and their growth prospects.
Conclusion
For investors, an equity income strategy focusing on Europe now more than ever offers the opportunity to tap into a number of favourable structural and cyclical trends. European companies, especially those on the Continent, now attach a higher priority to dividends. This allows investors to better exploit the benefits of an equity income strategy with a view of generating a superior total return over the long term. The growth of the UK equity income fund sector over the last ten years – now representing 57% of total funds – highlight the potential for this sub-asset class in the rest of Europe. Indeed, continental Europe faces a greater need for equity income due to more rapidly ageing populations and underfunded pension schemes than the UK, so a greater focus on income from equity than before would be entirely logical. Finally, the depressed level of share prices offers investors the chance to lock in high and sustainable dividend yields at unusually low valuations. This is particularly true for defensive stocks, which offer both good absolute and relative share price potential, and where dividends are relatively secure.
Source: Invesco
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