The Case for Global Dividends: Valuations and the Impact of Rising Rates
- Global dividend payers are undervalued relative to U.S. counterparts
- Valuations indicate the dividend trade has room to run—globally
- In rising rate environments:
- U.S. dividends historically underperform
- U.S. shareholder yield historically outperforms
- Global dividends historically outperform
- A focus on valuation and yield currently favors investments in Europe, Emerging Markets, global Telecom, and Energy
The S&P 500 Index has risen over 150 percent since March 9, 2009 in what could arguably be deemed the most hated equity rally of all time. The MSCI All Country World Index, one of the broadest global indices, has risen “just” 110 percent since its March 2009 nadir. Evidence indicates that United States (U.S.) investors have not participated in this rally—a truly sadstate of affairs.1It is worthy of noting that over the last several years a number of well known market pundits have viscerally rejected the equity rally due to macroeconomic concerns. The reality, however, is that stock returns are more highly correlated with the price you pay than macroeconomic events. The one place U.S. investors seem to have nibbled as they tip-toe back into the equity market is in U.S. dividend paying equities.
It is no surprise to the average investor that dividends are hot. According to Lipper $20.8 billion flowed into Equity Income Funds in 2012.2In a world oftwo-ish percent U.S. Treasury yields, who can blame them? Our team has long been a proponent of dividend yield as an investment factor. It works well in the U.S., but phenomenally on a global basis. Despite the rise in valuations of popular domestic dividend payers, we are unwavering in our belief that dividend yield will continue to be an effective character-is tic for stock selection long term. Our historical research indicates thatglobalhigh-quality, undervalued dividend payers tend to produce strong yield and risk-adjusted return.
But how does this historical evidence translate to the current environment? In the first half of the year, many dividend disciples have watched their portfolios fail to keep pace with the market. In the face of this seeming headwind, several questions have surfaced in our client conversations that are worth further examination.
Generally, those questions are:
- Is the dividend trade over?
- How will rising interest rates impact dividend-paying stocks?
- What opportunities exist in the global equity markets?
Below, we address each of these issues. And we think you will find the results intuitive yet surprising.
The Dividend Trade Has Lots of Room to Run—Globally
The reality of our demographic situation is that ten thousand baby boomers
per day will be retiring through 2030and the vast majority of them need to generate income in retirement. One often hears that as time goes on investors may gradually move their portfolios towards fixed income investments—leaving equities without a supportive investor. We do not believe this should be the case. As noted by Jim O’Shaughnessy in his recent commentary “A Generational Selling Opportunity for the U.S. Long Bond”, fixed income could prove to be a difficult asset class with which to generate income in retirement, let alone total return.3Meanwhile, continued financial liberalization and emerging middle classes in populous countries, like China, will likely provide ample buyers of global equities for the next several decades.
From a current perspective, dividend payers in the U.S. have become expensive relative to the U.S. equity markets.The highest divided payers in the U.S. are currently trading at a price-to-earnings ratio of 19.0✕, which is a 17 percent premium to the U.S. market. When we analyze dividend payers on a global basis, we find that they are 27 percentcheaper than their U.S. counterparts.
We believe these large valuation discounts justify a continuation of the dividend trade—globally. In our own global equity portfolio (Enhanced Dividend®) we have been able to find high-quality stocks at even greater discounts. The portfolio is priced on average at a price-to-earnings ratio of just 10.2✕ with a gross indicated yield of 5.1 percent.4
The Impact of Interest Rate Increases on Dividend Payers
The million dollar question of the day: “What impact do increasing interest rates have on dividend paying stocks?” Mathematically, we know that rising interest rates spell trouble for fixedincome investments—notably long-termU.S. Treasurys. Even for “spread” product that provide yield premiums above Treasurys, like corporate or municipal bonds, rapidly rising rates can cause significant issues.
Given the importance of U.S. Treasury rates on asset prices and the global economy, we looked at 10-year U.S. Treasury yields from 1927 through 2012 to identify periods where the yield increased greater than one percent in a 12-month period. There are 16 such instances since 1926, as is shown in the shaded areas of Table 1.
To determine the impact of rising rates,we review the performance of the highest yielding stocks in the U.S. and globally. First, we review stocks in the highest decile of dividend yield and shareholder yield from 1927–2012 in the U.S.5Next, we perform the same analysis on the highest decile of dividend yield and shareholder yield on global stocks from 1970–2012.6
Shareholder yield is a stock selection concept used in our portfolios that incorporates both share buybacks and also dividend yield in its assessment of yield.
U.S. Dividend Payers—A Fifty-Fifty Track Record with Rising Rates
In our analysis, the highest decile of dividend yield in the U.S. outperformed the market in eight of the 16 rising rate environments identified. The average annualized excess return to the top decile of dividend yield was -2.6 per-cent (as shown in Table 1).
As can be expected, a number of different factors have bearing on the performance of dividendpayers—secular trends in interest rates, inflation,corporate profitability, valuations, etc. For example, the significant under- performance of dividend yield in the 1998–2000 occurrence may have been more attributable to the bullish fervor which drove equity valuations to extreme levels. By late 2000, the price-to-earnings ratio on the S&P 500 Index rose to 30✕ trailing earnings. Dividend yield, which tends to favor value-oriented investments, would logically lag its high-flying growth counterparts during similar periods.
Also interesting is that the duration of rising rate environments is distinctly shorter after 1982. The average duration declines to 14 months from 40 months prior to 1982. A possible explanation could be changes in the monetary mechanism influencinginterest rates. In 1982, the Federal OpenMarket Committee (FOMC) first referenced a targeted federal funds rate.7
Alternatively, rate increases may simplymanifest themselves over longer periods in secular bond bear markets, as was the case prior to 1982. During the more gradual pre-1982 rising rate environments, dividend yield in the U.S. seems to do slightly better. However, our research leads us to believe there is a better stock selection factor in the U.S. to access yield in these rising rate environments.
A “Yield” Alternative to Dividends in the U.S.
Whereas the results for dividend yield in the U.S. in Table 1 suggest underperformance, shareholder yieldhistorically produces positive excess returns on average more consistentlyacross rising rate environments back to 1927. Shareholder yield outperformed in 12 of the 16 rising rate environments in Table 1 by on average +1.5 percent, making it the more consistentperformer of the two yield factors during rate increases.
On a longer term basis—and for the reasons outlined in our white paper “Why U.S. Investors Should Look Beyond Dividend Yield”—our team prefers shareholder yield as a stock selection factor in the U.S.8From 1927–2012, stocks in the best decile of shareholder yield outperformed the U.S. market by +2.8 percent onaverage per year with a superior risk adjusted return. This compares favor-ably with dividend yield whichoutperforms the U.S. market by just +1.3 percent per year on average over the same time frame. We believe this is partly because, at least over the last 25 years, U.S. companies have moved away from issuing dividends in favor of share buybacks. Shareholder yield is agnostic to the chosen form of dividend/buyback policy which allows a broader opportunity set.
Given these results and our historical research on the factor, we believe shareholder yield should be used as a primary stock selection factor in the U.S., instead of dividend yield alone. We now turn to the performance of dividend yield on a global basis in rising rate environments.
Global Dividend Yield Historically Outperforms in Rising Rate Environments
Domestic investors have traditionally allocated significant portions of theirequity investments to the U.S. because of a cognitive bias towards their home country, but doing so may place them at a significant disadvantage. According to the International Monetary Fund, the U.S. represents just 19 percent of global economic output on a purchasing power basis. Thus, indicating that investors are omitting a significant portion of the global economy from their portfolios—effectively operating with one hand tied behind their backs.9
This same home bias also causes us to extrapolate domestic perceptions and events onto the global market-place. The very question, “How will rising interest rates impact dividend payers?” betrays this bias. The simple answer is that rising U.S. interest rates can impact other countries and regions in myriad different ways.
To demonstrate, we perform the same rising rate analysis on the highestdecile of dividend yield and shareholderyield in the global equity market from 1970–2012. The analysis includes 11periods where U.S. Treasury yields increased greater than one percent in a 12-month period.In eight out of the 11 periods, the top decile ofdividend yield outperforms the globalmarket by on average +4.4 percent annualized.
Whereas, rising U.S. interest rates may have an impact on U.S. dividend payers, the historical evidence suggests that return benefits exist for portfolio exposure across multiple countries in rising rate environments. We believe this to be the case because individual economies are driven by economic, interest rate, inflation and currency regimes that operate some-what independently of each other.
As shown in Table 3, changes in these key economic metrics are lowly correlated across individual economies.
An Opportunistic Approach to Global Yield & Valuation
So far, we have established that global dividend payers are significantly undervalued relative to their U.S. counterparts and global dividend payers fair better in rising rate environments. The next question logically is how to separate the wheat from the chaff in the global equity marketplace. Though there are clearly benefits to broad global diversification in seeking yield, we believe portfolio allocations should ultimately be dictated from a bottom up perspectiveby underlying company fundamentals—notby geopolitical events, sovereign issues, or arbitrary benchmark constraints.
Our research has generally found that the freedom to make strategic allocations to areas of the market which demonstrate the bestopportunities in the characteristics we favor—value, quality, and yield—can be a significant source of long-term outperformance. Currently, we believe that there exist longer-termopportunities in high quality, undervalued names in Emerging Markets and Europe on the basis of geography, and Energy and Telecom on a sector basis.10This view is based on the discounted valuations as shown in Figures 1 and Table 4. Quite simply, these are relatively undervalued areas of the market with strong yields.
At times a benchmark agnostic approach characterized by high ActiveShare, such as ours, may result in whatappear to be concentrated exposuresin a given region or sector.11We argue,however, that in the context of a global portfolio, there often exists an under-appreciated level of diversification.
Take the Telecommunications sector for example—a significant overweight in our client portfolios because of its cheapness relative to other sectors and its high yields. Viewed through the lens of our Value Composite as shown in Table 4, the Telecom sector is cheaper than 70 percent of stocks in the global equity market. Only the Energy sector—another sector we favor in client portfolios—is less expensive on a global basis. Names in the Energy sector are on average cheaper than 73 percent of stocks in the global marketplace.12
Should investors view exposure to the global Telecom sector as a whole in the same way exposure to the domestic Telecom sector is viewed? The evidence suggests no. A break-down of the Telecom sector across 20 developed and emerging countries reveals that the correlation of returns with U.S. Telecoms is actually fairly low, an average of 0.21 since 1995 and currently also at 0.21 (see Figure 3). This low correlation suggests that even portfolios with high allocations to a single global sector can offer underlying diversification driven by multiple geographic exposures.
For example, during the 1998–2001 period of rising interest rates shown in Tables 1 & 2 for U.S. and global dividend payers, respectively, U.S. dividend payers struggled mightily while global dividend payers outperformed. During that instance the U.S. Telecom sector underperformed the global market by -1.1 percent. Mean-while, French, United Kingdom, and Japanese Telecoms outperformed by +33.4, +13.7, and +4.3 percent respectively. In other words, do not let the diversification tail wag the investment dog. Our team believes that taking advantage ofmispricings in the market is a key to long-term investment success.
Given significantly discounted valuations of the topdecile of stocks by global dividend yield relative to U.S. counterparts, we believe a continuation of the dividend trade is justified. As it relates to the prospect of increasing interest rates, historical evidence is inconclusive on the performance of U.S. dividend payers in rising rate environments. Other factors, like valuation, quality, and yield, likely have greater influence on future returns. A more effective total return factor in the U.S. over the long term, and in rising rate environments, is shareholder yield. Shareholder yield is the driving stock selection factor in our Market Leaders Value strategy. The strategy has a shareholder yield of 7.6 percent—200 percent greater thanthe Russell 1000 Value benchmark, and is priced at a 15 percent discount based on price-to-earnings ratio (as of 6/30/2013).
For those investors looking to maintain, or enhance, their equity income stream in a rising interest rate environment, our research suggests that a diversified exposure to dividend yield across the global equity marketplace could be a potential solution. Our Enhanced Dividend strategy seeks these high-quality global dividend payers and currently offers a dividend yield of 5.1 percent while priced at a 32 percent discount to the MSCI All Country World Index benchmark.
An unemotional approach to stock selection, based on valuation and devoid of consideration for news flow or geopoliticalevents, currently suggests a strategic allocation to select names in Emerging Markets and Europe, and Energy and Telecom.
1Reuters, “Insight: Mom and Pop Investors Miss Out on Stock Market Gains” (9/30/2012)
2Reuters, “Equity Income Funds No Longer the Only Game in Town” (2/20/2013)
3See http://www.osam.com/commentary.aspx (August 2013)
4As of 6/30/2013
5The Center for Research in Security Prices (CRSP), OSAM Research
6MSCI, OSAM Research
7Thornton, “When Did the FOMC Begin Targeting the Federal Funds Rate? What the Verbatim Transcripts Tell Us” (June 2005)
8See http://www.osam.com/commentary.aspx (March 2012)
9International Monetary Fund (2011)
10See “Emerging Market Opportunities” http://www.osam.com/commentary.aspx (June 2013)
11Active Share is defined as the percentage of a portfolio that differs from a benchmark index.Cremers and Petajisto (2006) found that active funds with Active Share of 80% or higher beat their benchmarks by 2.0–2.7% before fees.
12The O’Shaughnessy Value Composite consists of several factors, such as price-to-earnings and price-to-sales, to assess the valuation of companies relative to a universe of eligible securities.
Past performance is no guarantee of future results.Please see important information below.
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The material contained herein is intended as a general market commentary. Opinions expressed herein are solely those of O’Shaughnessy Asset Management, LLC (OSAM) and may differ from those of your broker or investment firm.
It should not be assumed that your account holdings correspond directly to any comparative indices. Individual accounts may experience greater dispersion than the composite level dispersion (which is an asset weighted standard deviation of the accounts in the composite for the full measurement period). This is due a variety of factors, including but not limited to, the fresh start investment approach that OSAM employs and the fact that each account has its own customized re-balance frequency. Over time, dispersion should stabilize and track more closely to the composite level dispersion. Gross of fee performance computations are reflected prior to OSAM’s investment advisory fee (as described in OSAM’s written disclosure statement), the application of which will have the effect of decreasing the composite performance results (for example: an advisory fee of 1% compounded over a 10 year period would reduce a 10% return to an 8.9% annual return). Portfolios are managed to a target weight of 3% cash. Account information has been compiled by OSAM derived from information provided by the portfolio account systems maintained by the account custodian(s), and has not been independently verified. In calculating historical asset class performance, OSAM has relied upon information provided by the account custodian or other sources which OSAM believes to be reliable. OSAM maintains information supporting the performance results in accordance with regulatory requirements. Please remember that different types of investments involve varying degrees of risk, that past performance is no guarantee of future results, and there can be no assurance that any specific investment or investment strategy (including the investments purchased and/or investment strategies devised and/or implemented by OSAM) will be either suitable or profitable for a prospective client’s portfolio. OSAM is a registered investment adviser with the SEC and a copy of our current written disclosure statement discussing our advisory services and fees continues to remain available for your review upon request.
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Notes:International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other nations. Investments in emerging markets can be more volatile.
Benchmark(s):The MSCI ACWI Index Net is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global developed and emerging markets. This index is net of withholding taxes. The MSCI World Index Net is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets. The index includes securities from 24 countries but excludes stocks from emerging and frontier economies making it less worldwide than the name suggests. This index is net of withholding taxes. The S&P 500 Index includes a representative sample of 500 leading companies in leading industries of the U.S. economy.
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