Asset-light, innovative companies can help navigate 2023

Q How have quality dividend growth stocks performed in 2022?

It is important to stress that our quality dividend growth universe is diverse, they all have strong market-leading positions with resilient cash flows. However, some offer high dividend yields and slower growth, such as your classic pharma and consumer staple companies, like Roche or Proctor & Gamble. While others have lower dividend yields but with faster growth, such as a Visa or a Microsoft*.

The companies with faster growth have had a more difficult time than the slower growth, higher yield companies because of the rapid adjustment of interest rates that are now being used to discount their cash flows. Put simply, they have suffered a material derating compared to the beginning of the year as the cost of capital adjustment was faster than their ability to compound. From our vantage point, these lower-yield faster-growing companies are now more attractively valued, as we have not seen a major change in their ultimate earnings power or their competitive positioning.

Overall, the picture therefore, has been mixed. We aim to strike the right balance of finding very good businesses that are very profitable, with resilient cash flows, that can compound ahead of the market but while also achieving the right dividend yield or valuation discipline.

QWhat are going to be the key drivers of quality dividend stocks in 2023?

We expect the market will get back to basics, where fundamentals of the companies will be the main driver of returns, instead of macro factors. This environment would be more suited to our investment style.

We don’t necessarily think there will be less volatility or that the geopolitical environment will become less difficult, but we expect interest rates and inflation will become less of a factor, as leading indicators of inflation are already softening. Having said that, the impact of higher rates and the Fed balance sheet reduction typically comes with a lag. We would expect to see the damage on earnings growth of individual businesses from higher interest rates and tighter financial conditions very clearly in 2023. We would, therefore, be very careful of any business that was a major beneficiary of zero cost of capital, quantitative easing, and debt.

Therefore, with discount rates becoming less of a factor, we wouldn’t expect companies to see a material further derating. Valuations are now starting to be more attractive, so focus should return to companies that can deliver growth. Next year we might end up in an earnings recession, so it will be harder to find companies with the ability to deliver decent growth from their 2022 base. This means investors will need to be far more selective. We expect companies with the ability to not only pay but also increase dividends due to resilient cash flows to do well. This will especially be the case if they are not reliant on capital markets to fund their growth and have pricing power through innovation, which in turn can add value.

Q In an inflationary environment, should investors consider asset-intensive businesses?

We would argue against the consensus here. Asset intensive businesses are not the answer to combatting prolonged periods inflation, as such assets require maintenance capex that will adjust with inflation, which will be a drag on cash flows and dividends. Conversely, asset-light companies that are focused on innovation are important and can be very valuable when growth is hard to find and inflation high. Such companies can generate their own demand and people will be prepared to pay for it, especially if they can help save consumers or businesses costs or solve a real-world problem. Many of these companies offer are a “build once, sell many times” business model, which means revenue can be turned into free cash, which can be used to pay a growing dividend.

Q Where do you see risks in 2023?

When we think about quality dividend growth stocks, the risk is not really in the form of permanent loss of capital, as we prefer investment-grade assets with almost no debt. Equally, our universe typically has a dividend yield and earnings growth expectation that are above the broader market, with a lower funnel of uncertainty.

Consequently, we think of risk more at the individual stock level. We need to make sure that the growth embedded in the valuations will ultimately come through, as all companies have some degree of cyclicality; it just depends how much. Getting the value and growth equation right will be a key driver to performance in 2023.

*No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided.