John Teahan

John Teahan

Portfolio manager

The big breakup

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The recent divorce of value and income has been brutal. It was sudden, unexpected and has thrown down a huge challenge to investment strategies run by us and many others. It has forced The Investment Association in the UK to abandon its income test for their Global and UK equity income sectors (here), while non-income focused investors see an opportunity to put the boot in (here and here). Investors are now asking if value is the right investment style to deliver equity income, was the relationship ever really what it was made out to be, and can it ever be the same again? It was neat to equate the two so closely, it suited us and probably fund pickers as well. Having accepted truths makes life easier and less stressful. The split of value and income blows the existing categorisation apart and forces a rethink.

Why had value and income traditionally aligned? Firstly, it is easy to understand why a growth style of investing does not align with income as cash flows are reinvested as the business grows. Rather than distributing dividends, growth companies more often raise capital via selling shares. Therefore, it falls to the more mature businesses to deliver income. Mature businesses have less opportunity for growth and therefore can distribute a part of their profits to shareholders. It is within this category that the debate over equity income now rages: value stocks versus defensive stocks, the latter often referred to as quality stocks, bond proxies or expensive defensives.

Value stocks were traditionally aligned with equity income because low valuations were accompanied by a high dividend yield. Simply put: for two stocks with the same pay-out ratios, the stock with the lower price earnings ratio had a higher dividend yield. There was also a distinction within value: value investing for equity income was for the most part not ‘deep’ value or ‘recovery’ investing. The latter plays more on companies that have gotten into trouble, rather than merely out of favour, and dividends are usually suspended in such situations. Indeed, the posterchild stocks of today for secure dividends were often comfortably classified as value stocks. It is a natural rotation that stocks and sectors enter and exit the value universe through time. A historical chart plotting the total enterprise value to revenue ratio for Nestle illustrates how at times the stock comfortably sat in an equity income value portfolio, but not now.

Figure 1: Nestle S.A. Total Enterprise Value to Revenue

Source: S&P Capital IQ, 30th April 2020.

The big challenge to the value approach in delivering equity income this year is the widespread nature of dividend cancellations and cuts. Traditional income stocks such as telecoms, energy, banks, and insurers are all cutting or cancelling at the same time, and typically you might have had one or two industries at a time getting hit with cuts (energy and materials in 2016). Prior to the GFC, dividend cuts in Europe never exceeded 10%, even when EPS declined by up to 40%[1]. The synchronised nature of the cuts in the last two months has been brutal. The value universe has become ‘deep’ value. 

Where to turn? Secure income requires a compromise on valuation. The 13 top global Household and Personal Products (H&PP) companies offer an average yield of 1.9% (gross of withholding tax), while food, beverage and tobacco companies offer an average yield of 3.1%. The latter sounds relatively attractive but exclude the tobacco companies (with apparent dividend risk as seen by Imperial Brands’ recent dividend cut) and the yield falls to 2.4%. Focusing on the safer H&PP group, if we grow the 1.9% by 5% per annum it takes ten years to get to a 3% yield, hardly that attractive but perhaps all we can expect in terms of a secure, predictable income when sovereign bonds offer zero or negative yields. Meanwhile, the average price to earnings ratio is 30x for this group of companies, were that multiple to contract then the capital value is at risk of reducing significantly. It may transpose an income problem this year into a capital problem next year were these stocks to de-rate back to long-run average multiples. Of course, this ignores the weaker organic growth and potential margin pressures even these quality companies are faced with, potentially undermining the 5% dividend growth assumption.

There are no easy answers for investors, but plenty of hard questions and some very honest conversations to be had. Howard Marks recently said in an interview that “value stocks are more defensive than growth stocks, usually”(Real Vision – To catch a falling knife”).Not this time. This has been a drawdown focused on value that has also taken down the relationship value had with income. I believe it will be resurrected, but investors will have to take the pain for a period to get to that reconciliation. The reconciliation is also likely to be accompanied by significant capital gains, as earnings return and multiples decompress… you may imagine this, if you will, as a sort of make up gift from value stocks for all the hurt and pain of today.

[1] ‘Unprecedented pressure on dividends’, Morgan Stanley Research, 2nd April 2020.

The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited.This article does not constitute investment advice and the information shown above is for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment

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