Why investors should consider US equity income in a portfolio

Please Note: Below is a transcript of the video, modified for your reading pleasure. Please check the corresponding video before quoting in print, as it may contain small errors.

Now, Fiona, the US stock market is not really known for its dividends. In fact, I think your fund yields about 2%. Why is the yield low in the US, and why should investors still consider investing in a US equity income fund?

[00:34] That’s a great question and you’re absolutely right. I think the long-term yield of the S&P 500, if we use that as a proxy for the overall US market, is about 2% and it’s always been lower than the UK market. Now, it’s not that the US hasn’t had a history of paying dividends – I think we’ve all heard of the dividend aristocrats, those companies that have consistently paid a dividend for 25 years or more – It’s just, what do you use your excess cash for as an individual, as a company?

And when you think of it as a company, there’s lots of things you can use that cash for. Some of it can be given in dividends. Some of it can be given in buybacks – so you buy back your shares, reduce the number of shares outstanding, and your earnings per share increases.Some of that is used to pay down debt, which we all think is a great thing to do. Some of it is used to invest in the business itself, maybe make an acquisition. And then some of it is again, just capital allocation, I think is what we’re thinking about here. Some of it is used for capital expenditures, buying equipment and increasing productivity.

So, US companies are in great financial shape. They’ve got an awful lot of cash. They’ve just got a lot of uses for it and they make good use of that cash. So, if you think about the US stock market over the last three years, five years, it’s up double digits on an annualised basis. And those returns have been delivered because of those investments from companies. So, I think that’s really important. You’ve had good returns from the US market because companies have invested wisely. And so, it’s not always in the shape of giving you and I a dividend.

But the other thing to think about in regards to dividends in the US, is not just why it may be a lot less than in the UK market. It’s very diversified. If we look again at the S&P 500, you’ve got 11 major sectors, six of those 11 sectors yield 2% or more, and every sector has a dividend. So, I think there is a history of dividends, we just don’t get it to the same level. And even within the S&P, about 79% of the S&P companies pay a dividend, and about 250 companies have increased their dividend this year. So, I think there is a history of dividends in the US marketplace, but it’s not just the only source of cash. I think that’s really important.

And, at the end of the day, by having that balance of dividend investing versus investing in the company itself, or doing buybacks, or doing acquisitions, means that you get a better return, hopefully, from the stock market, not just one driven by dividends alone.

You mentioned the dividend aristocrats then – are these the sort of stocks which you’re looking for in the fund? Those companies which can pay these dividends and grow those dividends for years and years like Johnson & Johnson? Is that a company you like, for example, and there are there other examples?

[03:44] Dividend aristocrats are really a good indication that the US market is a dividend market, but it’s not something we feature in our portfolio. It’s not a rationale for investing in the stock. Our process is very simple. We want to invest in quality companies that are attractively priced, that pay a dividend of 2% or more. And dividends come last for us. Quality has to come first.

So, a company with a good management team, a really strong competitive advantage, good balance sheet, consistency of earnings. And if we get those companies at an attractive price, that have an ability and an intent to pay a dividend, we should be rewarded long term. But you’re right. Johnson & Johnson has been a holding in our portfolio for a number of years. And when we say long term dividend payer, I think it’s about 50 years or more that they’ve actually been paying the dividend.

And they’re not the only company, we’ve got companies like Coca-Cola, but that’s not the reason we hold them. We have to have that quality aspect, that good management team, that good balance sheet and attractive valuation. And if we think about healthcare in general, which is where Johnson & Johnson sits, it’s been a sector that’s been very much under pressure for the last few years in the US market. There’s been talk about regulation. There’s been, of course, if you haven’t had a COVID drug, you’ve been left behind. And so, the sector actually started trading at very attractive multiples over the last two years. And when you’ve got an attractive business, at an attractive valuation with a good dividend yield, that’s what we’re looking for.

And Johnson & Johnson definitely hits that spectrum. And so, when we look at the quality of the business, their pipeline, at their balance sheet strength, and we get the yield of 2.6%, it makes a compelling valuation as well. It makes it a compelling offering to have included in the portfolio. So that’s why we like the company. It’s the fundamentals. It’s not because it’s had a history of paying the dividend. And that’s really important, because what we recognise is that in times of crisis or stress, if you’ve got a good balance sheet, you can weather those challenges, including sustaining your dividend over those periods. But also, that you’ll get a better return from these companies as well.

And, happily, the fund has performed very well year to date. I think you’re about 7% ahead of the S&P [500] when I last looked. Why is that?

[06:22] It’s a great place to be, particularly when the marketplace is in such a negative turmoil at this moment in time, to deliver positive returns for clients. We look at the process that we employ, as we talked about. It’s very simple. It’s looking at the fundamentals, those quality companies that are attractively valued, that pay dividend. Now, irrespective of what comes in or out a favour in the markets, they’re the characteristics of our investments. And it’s time tested. It’s the same process that has been in place since we launched the fund in 2008, and when we launched the strategy two decades ago. So, whether the market likes value stocks, small cap stocks, large cap stocks, midcap stocks, growth stocks, tech stocks… it doesn’t matter to us. It’s the same process we have followed.

And by focusing on those quality companies with good balance sheets, good characteristics, they typically do well in periods of turmoil in the market. And that’s what we’re seeing right now. Those companies are really executing so well, the market is recognising that leadership when it has so many other concerns and so many other risks. And it’s amazing how quickly the market turns. If we looked at this portfolio a year ago versus the S&P 500, it would not have looked half as attractive in terms of returns. But again, sticking to your process, recognising that it will come around at some stage in terms of the market. It’s very rewarding when you hit those periods.

And what is your view on the outlook for the US economy and the US stock market for the rest of this year and for 2023?

[08:03] I suppose that’s the question that the market has been trying to answer all year. It started in a nice return fashion in January and we saw financials do well and the prospects of interest rates rising. And then inflation fears gave way to recession fears. The market now recognises that inflation may have peaked, but it peaked at a lot higher rate than many expected. And the Fed has been a lot more aggressive on raising rates than we would’ve anticipated at the start of the year.

But what we do know is the economy this year is growing, but it’s growing much slower than it did last year. We also know earnings are growing, but they’re much lower than they were last year. And the market is trying to absorb this information and trying to figure out, do we go into recession in the next 12 months or don’t we? And frankly, it’s probably a coin toss. It’s probably 50-50, whether we have a recession or we don’t. But at the end of the day, what we do recognise is we are having an economy that is slowing in terms of its growth. And that’s really important. Because, at the end of the day, what happens in the economy comes through in terms of corporate earnings. And so, what we can recognise is that earnings are still growing and we expect them to grow this year and next year. The multiple of the market has got cheaper and that’s because the price has gone down, that we’ve had earnings growth, that positive earnings growth for US companies.

So, if we have that economic slowdown, even if we have that recession, our thought process is that it won’t be a prolonged one. It doesn’t feel like there’s excesses in this economy right now or this market where we had a prolonged one like we had in the global financial crisis. We’re not going back there. There’s no housing bubble. I would say, there’s no tech bubble. It doesn’t feel like there’s a bubble in the US economy, any place. So, we may have that recession. We may just have an economic slowdown, but the earnings are still good. And I think that’s really important when we’re looking at the companies in the portfolio, that we’ve got those names within it.

And I would say normally, when the market sells off, we are full of activity, we’re full of adding names to the portfolio. Right now, we’re not doing a huge amount in terms of adding new names, because we’re looking at the earnings. And that’s really important. You have to have conviction in the earnings for the next 12-24 months if you want to step into some of these names. So, some of the names that are most beaten up, we don’t have that real strong conviction that earnings are going to be good over the next 12-24 months. We think some of these companies will struggle over those time periods. So, we’re not buying really the whole market in terms of what’s the cheapest out there. We want the highest quality, and we feel right now, we’ve got those names within the portfolio. So, whatever happens to the economy, our names should be able to navigate it well.