Why dividends tell us that earnings may be overbaked
Against a deeply uncertain backdrop, the market still expects earnings to trend higher this year. Dividends, however, tell a different story. Abrie Pretorius explains more.
23 Nov 2021
Hear from Portfolio Manager Abrie Pretorius on why he expects companies with a greater proportion of intangible assets to be able to protect their cash flows in 2022.
We have gone full circle since the start of COVID about two years ago. If you look at global revenue, it is now about 2% higher than in 2019 but I think the real story is probably about profits, which are up almost 40% compared to 2019. Companies really delivered very strong operating leverage, especially during 2021. This was largely by sectors such as energy, consumer cyclicals and the cyclical areas of tech, where demand returned but without the full extent of their cost bases returning to normal.
So, I think we are now really seeing cost rapid returning, with inflation running hot. So, I think, as we look into 2022, the interesting thing will be that COVID clouds will lift, and we are probably going to start getting a clearer picture in terms of the real demand and cost pressures that companies are facing.
Revenue growth is likely to slow materially as we enter 2022 and the risk is that the costs we are seeing now stay elevated. That is going to force central banks to accelerate liquidity withdrawal and the interest rate cycle at a time when we are seeing a rapid deceleration in growth.
It is free cash flows that drive share prices, not earnings, so we are quite wary of the businesses that have got high reinvestment costs at a time when those costs are elevated. So, we steer more into businesses with strong intangible assets that can deliver strong revenue growth and can have that revenue growth pass through to cash flows. This is possible because they don’t have the high reinvestment requirements as their asset bases are really driven by software, code, patents and brands.
We think that companies with very strong track records of growing dividends are likely to do well. Specifically, we favour the businesses within the consumer, some select software and healthcare spaces. The common theme here is these are companies with a good combination and mix of offence and defence, but they have got capital-light balance sheets as they don’t have high reinvestment requirements. We believe this issue of the cost base increasing rapidly in 2022 may catch some investors off guard as many focus on earnings and not cash flow.
We own a limited number of businesses that we think will be able to again deliver real dividend growth next year. They possess strong pricing power, which will keep up with the demand environment but don’t have the high reinvestment costs that most other businesses have. Therefore, they should be able to deliver very strong free cash flow growth once again.
We believe 2022 is going to be a year in which quality drives growth. It is important, as we have a lot of different distortions in the market, to be very selective and diversified geographically. Europe, the US and emerging markets have all got very different restrictions that are driven by the local governments and so investors need to be able to identify unique drivers of the individual businesses that can drive growth in 2022.
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With Western central-bank policy normalising, economic growth rates diverging and global trade still readjusting to life after lockdown, investors have a complex environment to navigate in 2022.
Ninety One’s portfolio managers assess the outlook across their asset classes and regions.
Our team also takes a deep dive into the outlook for emerging markets, as well as into how sustainability will drive investment outcomes next year and beyond.