Hear Abrie discuss the outlook for investing in quality dividend growth companies.
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.
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.
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.
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.
General risks. All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific risks. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company.
*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.