Why a dividend growth strategy is prudent in an elevated rate environment

Inflation is proving stickier than expected, meaning rates may remain at elevated levels. Abrie Pretorius, manager of Ninety One’s Quality Dividend Growth Strategy, believes that identifying companies that effectively allocate and reinvest cashflow is paramount for investors to deliver attractive total returns in today’s environment.

18 Apr 2023

4 minutes

Abrie Pretorius

The investment landscape has shifted markedly over the past year, but the need for investors to find an optimal balance for their portfolios has not.  We believe dividends are a critical ingredient in managing this dynamic, irrespective of the macro backdrop. However, given the sharply increased rates, and the fact that money market funds are offering ~4% yields, investors need to look beyond lower quality high yielding dividend payers and towards companies with strong balance sheets that can sustainably grow their dividends. 

For us, cashflow is king. Dividends are the residual once all capital requirements are satisfied, and they cannot increase without growing free cashflow. Therefore, we believe the ability to identify companies that effectively allocate and reinvest cashflow is paramount for active investors to deliver attractive total returns.  

Quality characteristics 

High-quality companies, as we define them at Ninety One, have enduring competitive advantages that are derived from intangible assets such as brand, intellectual property, unique content, networks, and strong supply chains. These strengths provide quality companies with barriers to entry and pricing power, which in turn enable them to deliver long-term structural growth and resilience, and compound cashflows at sustainably high levels of profitability. 

Often, these companies have innovative business models. Quality companies that are future proofing their businesses by investing in R&D are better equipped, in our view, to drive product innovation and in effect create their own demand. This not only contributes to self-funded future growth, but also serves to strengthen a company’s competitive position. 

Consistent leaders

Take Microsoft1, for example, which not only has transformed its business model over the last decade and innovated across the technology stack, but is one of the most consistent dividend payers in the world, with its product pipeline funding healthy and often growing distributions since 2003. Examples can be found across the world. Siemens Healthineers, an innovation pioneer in healthcare – based in Germany – has become a leader in medical imaging and image-guided therapy (IGT), driving improving quality of care for all patients while reducing healthcare cost through innovation. Despite the economic disruption caused by COVID-19, the company has been able to grow its dividends at a 9% compounded annual rate over the past four years. 

By contrast, in periods of stress – such as the one we’re in today – companies with indebted balance sheets face higher interest costs, which will eat up capital that could otherwise be invested in the business or distributed to shareholders. Likewise, asset-heavy companies now face inflated capex requirements that will hamper future growth. Investors are often left facing a cut to their payout – combined with poor share price performance – generating a suboptimal total return profile.  

Building a portfolio of compounders 

Investors must also be cognisant of valuation, and make sure they are not overpaying for the future growth of the company, as occurs with many growth investments. A quality dividend growth approach offers the best combination of both valuation and growth, in our view, through the rigorous focus on innovative dividend paying companies that compound and grow their cashflow base. These companies won’t necessarily have an especially high initial yield, either. The key is that it is well placed to grow through time. Healthcare leader Johnson & Johnson has increased its annual dividend for 60 consecutive years, for instance, navigating every market environment imaginable.  

We believe that it is prudent to adopt a quality dividend growth approach in this elevated rate environment, by investing in companies with low levels of debt, that have smaller earnings headwinds due to higher interest payments, and can continue grow their capital base and dividends. Over time, a portfolio of such companies can compound and deliver a much superior risk adjusted return profile than both growth and value, providing durable alpha through different market cycles. Ultimately, such a strategy can help provide greater certainty in an uncertain world. 

 

1 This is not a buy, sell or hold recommendation for any particular security

Authored by

Abrie Pretorius

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This communication is provided for general information only should not be construed as advice.

All the information in is believed to be reliable but may be inaccurate or incomplete. The views are those of the contributor at the time of publication and do not necessary reflect those of Ninety One.

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