Investors are transitioning to a markedly different but probably more “normal” investment environment characterized by lower returns and greater volatility.
Investment returns depend on one's starting point, and 2012 lacks growth levers.
Interest rates are already low, and valuations and corporate margins are above average. Austerity will be a drag on growth.
What's more, volatility is likely to be higher due to the variable pace of deleveraging and state intervention.
Politicians plan for the short term, and policy initiatives therefore are more likely to address the symptoms rather than the cause of our indebtedness.
All this will create distortions and uncertainty, and will encourage speculative capital flows — and is likely to extend the period of depressed economic activity.
In a low-growth world, dividend yield will be crucial for generating equity returns.
Returns from equities come from dividend yield, dividend growth, earnings growth and changes in multiples.
During the past 40 years, dividend yield and dividend growth combined have contributed about 78% of total returns from U.S. equities and nearly 100% in Europe. Lower economic growth will lead to lower growth in earnings and dividends.
Heightened macroeconomic uncertainty tends to have a dampening impact.
Dividend yield therefore appears to be the most likely candidate to drive future total returns.
In a more volatile world, investment strategies should seek to produce a return with lower volatility, particularly on the downside. An asymmetric investment strategy, making money at times of rising asset prices but losing less when prices fall, is appropriate.
A focus on income has proved traditionally to be less volatile than a growth-oriented approach to equity investment and has had a “protective” quality during market downturns.
Dividend yield and dividend growth tend to display significantly lower volatility than earnings growth and multiple changes.
Once a dividend is established, companies tend to try to keep paying it to avoid sending a negative signal to the market.
As a result, earnings growth tends to be three times as volatile as dividend growth.
Higher-yielding stocks also tend to go down less during market downturns. One possible explanation is that during market downturns, investors are drawn to the relatively stable earnings and dividends from defensive high-yielding equities.
The final reason that one might consider high-yielding equities is due to their strong total-return track record over the long term. During the past 25 years, a basket of global high-yield equities has returned 11% per year, thus outperforming global equities by 3.2%.
One might consider selecting carefully among global stocks with above-average dividend yields.
To ensure asymmetry of return, the focus should be on creating a portfolio beta well below 1 by investing in high-quality companies with strong balance sheets, and relatively stable earnings and dividends. This tends to focus portfolios on larger companies, selling more nondiscretionary products or services, such as health care, pharmaceuticals, telecommunications, tobacco, utilities, oil and gas, beverages, cleaning products and food.
High-yield sectors in which we would be highly selective are those that have relied on the past decades of a credit boom for their revenue. For example, earnings growth in some parts of the financial sector has been well above average for a long time, but most likely will see no growth or a decline going forward.
We also would be very careful about investing in highly indebted companies. In a low-growth environment, debt pay-down is very slow, and minor business setbacks will create significant earnings volatility.
Finally, for many years, Western consumers have spent more than they have earned by increasing their leverage.
A transition to more-balanced household budgets will mean a reduction in spending, and we recommend being very selective among discretionary consumer product and service companies.
Tineke Frikkee is lead manager for United Kingdom equity income strategy at Newton Capital Management Ltd.