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“Why the historically attractive yield gap is being overlooked by investors and why the time has come to rebalance portfolios towards high dividend equities – at least in part”
At a time when a large number of fixed income products are offering a negative yield (see graph 1), with so much money desperately waiting on the sidelines to be invested, it is striking that the so-called yield gap, the difference between the market (including European) expected dividend yield and the fixed income “bond yield”, remains close to a historically high level, with some European dividend funds set to return an attractive dividend yield averaging 6% for their portfolio in 2019 whereas a large portion of the fixed income market is no longer yielding anything at all.
Chart 8: Global stock of negative-yielding debt
Source: BofAML Global Investment Strategy, Bloomberg
In this note, we will look into the drivers which enable high dividend funds to build a portfolio presenting these characteristics with their attractive valuation features, and in a second step we will attempt to argue that a rebalancing (at least for those investors massively overweight in “growth stocks”) in favour of a high dividend/value style might make a lot of sense at this point.
First of all, while many commentators talk about expensive equity markets (e.g. the European market valuation multiple is currently slightly above the long term average), a more nuanced and interesting underlying reality tends to remain hidden. As a matter of fact, since the 2008 financial crisis, a huge polarisation trend has been taking place between the valuation (and performance) of stocks exhibiting “growth” characteristics and those offering “value” characteristics.
In mechanical terms, multiples paid for stocks capable of delivering structurally higher growth will move up as the cost of capital comes down (or the bond proxy part of equity market negatively correlated with risk free interest rates). On the other hand, more mature companies (for the sake of simplification, the “value” end of the market), offering a lower growth outlook and adapting their capital allocation policy accordingly (e.g. returning cash to shareholders through dividends rather than investing for growth), do not benefit from this “growth repricing” trend. Furthermore, this segment also tends to be more exposed to phenomena of technological disruption (e.g. physical real estate shopping centre suffering from structural retail decline due to the emergence of e-commerce).
What’s more, this high dividend universe is currently biased towards cyclicals and is therefore often positively correlated with inflation and/or interest rates (with Financials being the most obvious example).
In the light of the macro developments of the last few years (weak global growth, weak inflation and interest rates constantly revised downward), it is thus not surprising to observe a strong valuation expansion of the growth style versus the value style (see graph 2). This has resulted in a high dividend universe concentrating on a more limited number of sectors/themes than usual, as the rise in valuation of the defensive growth segment has led to a less attractive expected dividend yield for that segment.
Overall, the implication of the very low interest rates environment has led to the valuation of high dividend securities screening very cheaply compared with history, not only against bonds, but also against “growth” stocks. Indeed, taking the High Free Cash Flow to Enterprise Value (FCF/EV) segment of the market as a proxy for high dividend equities (which is fairly intuitive as sustainable high dividend equities usually come from companies with a decent balance sheet and which are able to generate high free cash flow in a sustainable way), it appears that the discount on which High FCF/EV equities currently trade versus the market has never been as high since the Tech bubble (see graph 3).
Source: Exane BNP Paribas. For valuations we have compared the Relative PE multiple of the Top bs Bottom Quartile of stocks. FCF factor has been on an ex-financials universe.
More interestingly, this is happening at a time when the relative earnings momentum of value versus growth is not supporting such a significant move in relative valuation/performance (see graph 4). In other words, the bulk of the underperformance of high dividends stocks versus the rest of the market cannot be explained by a more disappointing earnings trajectory. Of course, and to be fair, should ultra-low interest rates prevail for a number of years, the earnings profile (and long term dividend sustainability) of many value/high dividend pockets would come under pressure. But the trend so far is resilient and one could argue the depressed valuations could accommodate some earnings/ dividends cuts.
Value vs Growth N12M EPS Index
Source: MSCI, IBES, Morgan Stanley Research
Finally, indications from policymakers across the globe are starting to build on complementing monetary policy with fiscal expansion to revive global growth in an effective way. For example, ECB President Draghi has recently hinted about the marginal efficiency of new monetary policy measures such as QE to boost economic growth. Some are going even further by discussing the side effects or even counterproductive effects of such policies. The point is that as more people recognise the need for fiscal easing, inflation expectation may eventually stabilise and move up, which could cause a substantial turnaround in the market away from growth into high dividend/value equities. Theoretically, this move could be huge in the light of current investors’ positioning, as they have shunned the value end of the market in favour of parking money in “bond proxies” and the “growth” style.
In conclusion, while the long term arguments favouring high dividends securities remain unchanged (dividends making up the bulk of long term shareholder return and offering a cushion in correction phases of the market), the last decade has not been favourable to such a style. Given extreme positioning and attractive relative valuations, as well as supportive relative earnings momentum and economic policies potentially moving towards fiscal stimulus, the rebalancing of portfolios towards high dividend securities at this point could make a lot of sense.