Aaron Barnfather, manager of the Newton European Higher Income fund, highlights why European equity investors have so much for which to thank higher-yielding equities - whether they know it or not
The huge strides made by European dividend levels in recent years - they have jumped some 50% in the last few years alone - might lead the casual observer to think dividend yield is something of a recent twist in the European investment story. This however, could hardly be further from the truth.
As historic research demonstrates, in the 25 10-year rolling periods from 1972/82 to 1996/06, no less than 78% of total returns from European equities were garnered from dividend growth and dividend payments (see Chart 1). Importantly, the chart also illustrates how the 'bad old days' - when companies allowed the value of their dividends to drift in poorer times - now look to be well behind Europe.
The fact that this probably comes as something of a surprise, considering Europe's previously muted reputation for dividends, helps to underline the importance of such payments. Despite the hiatus of the technology bubble in the late 1990s, there is nothing that has accounted for nearly so much of a European equity investor's total returns over the last quarter century as dividend payments.
Divvying up
The explanation for the impact of dividend payments on long-term returns is simple. Regardless of the prevailing climate for equities as a whole, dividend yield is always positive. It's the impact of this positive income stream being reinvested over time that has such a marked impact on returns. Another factor is that while higher-yielding stocks tend to keep pace with a rising market, their true value is only underlined when markets go into decline.
Historically, returns from higher yielding stocks in markets such as the UK have recovered from troughs in market sentiment far more quickly than the broader market. This is partly because strong company earnings and high dividend yield are two of the defining characteristics of the 'defensive' stocks to which equity investors migrate during periods of declining market sentiment. As earnings from these companies tend to be consistent and strong, and changes in valuation modest, they are better able to shoulder market downturns while their dividends provide investors with a degree of insulation from more difficult market conditions.
By contrast, stocks with lower dividend yields are forced to rely more upon valuation changes to drive their returns over time, making them more volatile. There are few better illustrations of this than the TMT (technology, media and telecoms) boom of the mid to late 1990s when valuation multiples such as P/E ratios for lower-yielding stocks rocketed away from those of dividend yielding stocks only to fall back even faster.
Although it might at first seem counter-intuitive, recent academic research has also revealed that companies with the highest dividend payout ratios historically show the greatest levels of earnings growth*.
This would seem to suggest a virtuous circle for those companies able to maintain the rigorous financial discipline that high dividend payments entail, which bodes extremely well for Europe's emerging income stocks. Even so, successfully piloting Europe's increasingly dynamic markets still requires a truly focused approach.
Flying high
This is where the yield discipline that underpins each of Newton's equity income funds comes to the fore. In the case of Newton European Higher Income fund, this discipline requires that any new holding must offer a prospective yield 15% greater than that of its domestic equity market, while any stock whose yield falls below market levels is immediately sold.
By ensuring that each and every portfolio holding delivers a high yield, the fund represents a uniquely disciplined proposition that targets a gross yield of between 4% and 4.4% at launch (see below).
Meanwhile, Newton's unique sell-discipline means capital is constantly recycled from those stocks that have already made strong progress to those best placed to do so. Such yield discipline frequently means that Newton's equity income funds will book all of the profits on a strongly performing stock, even while competing funds may be restrained by index considerations.
With signs that global growth and earnings could well face headwinds from here, such yield discipline might be just as well.
*Source: Arnott and Asness (2003). 'Surprise! Higher Dividends = Higher Earnings Growth,' FAJ vol 59, no. 1.
