Find yield and deliver: income opportunities in Europe

Chart 2 is far from reassuring. Since early 2009, riskier stocks with high leverage (borrowing) and stretched balance sheets have performed well compared to the 'quality' stocks (ie. those which pay regular dividends and entail less risk) that comprise the majority of our dividend-paying universe.

With the glorious power of hindsight, one can see why this trend has been in place. We live in a world awash with central bank-induced liquidity, and we have witnessed an extraordinary government-led recovery from the precipice of economic ruin. Th e coordinated global response, involving vast and unprecedented quantitative easing, is, at root, infl ationary for the prices of stocks, bonds and commodities. For those stocks previously priced for bankruptcy, or those which are heavily cyclical, or both, the upswing in their values, and hence their prices, has been dramatic; the market has thrived on earnings upgrades that have beaten expectations by a wide margin. However, we do not believe that this recovery from disaster, and the spectacular recovery in the pricing of risk assets, is the 'new normal'.

The first dividend payments were a European phenomenon. At the turn of the 17th century the Dutch, who had stolen a march on the Portuguese and the British, were enjoying a roaring trade importing spices from the East. However, it was a risky business. Companies were set up to fund single voyages, exposing investors to a concentration of multifarious hazards including piracy, shipwreck, disease and price collapses.

In 1602, the world's first joint-stock company, the Dutch East India Company, was formed, and several different trading enterprises were consequently enveloped in one single ownership structure. Risk was shared and the profits were divided up and paid out at periodic intervals to all stockholders. The dividend in its present form was born. As profits increased, so did dividend payments, and the Dutch East India Company's stock price rose as investors bid prices higher, reflecting the company's success. Modern investors should never lose sight of this simple relationship. Companies which have the ability consistently to place more cash in the hands of investors should see a commensurate increase in their share price.

Fast-forward 400 years, and dividends are once more central to investing in Europe. Since WWII, the continent has emerged from more than half a century of impressive growth, during which companies retained cash for investment, to find itself a relatively mature market. There are now only select opportunities for expansion within Europe, and even in fast-growing emerging markets it is important to tread with care. As a result, European companies have cash on their balance sheets, and are able to distribute profits in the form of dividends.

Continental Europe now yields more than the UK, despite the established dividend culture in the latter. Even the Swiss pharmaceutical giant Roche has followed suit: for many years a bastion of growth, the company, in a break with its established tradition, dedicated a whole page of a recent investor presentation to its progressive dividend policy.

It might be said that the maturing of Europe's economy, signalled by increased dividend payments by European companies, is bad for investors; but there is much evidence to the contrary. Look across to America and it is clear that €1,000 invested in the S&P 500 Index in 1957, with dividends reinvested, would have turned into $60,586; an identical investment into the top 20 per cent of the Index, by yield, would have become $577,587.¹

Alternatively, as the analysis from Société Générale in Chart 3 shows, high-yield stocks have outperformed an equal-weighted benchmark in all regions since 1988.

In other words, it hasn't been the very high growth companies that have outperformed. Why has this been the case? Growth is hugely important, but it comes with risk attached. American railways initially promised fabulous growth, but time and time again disappointed investors, as the returns never matched the huge capital required upfront. Parallels can also be drawn with the 'tech bubble' at the end of the last century. The truth is that for every Microsoft or Google there have been a hundred failures. Will Facebook ever turn its magnificent global reach into magnificent cash returns to shareholders? The jury is out.

In our European universe, we were asked by a recently-listed Swedish retail company what kind of dividend, as investors, we would like. The company is cash-generative but also has good growth prospects in Scandinavia. So we drew a hypothetical template of our perfect company, if it exists, and asked for 50% of the profits to be retained for growth and 50% to be paid out to shareholders. To us this is preferable, on the whole, to investing in a company with 20% growth in sales which is trading on a highly stretched valuation, and which sets out to reinvest every dime it might or might not ever earn.

So why should dividend-paying companies, often with moderate growth profiles, outperform? The attractions of income to investors are clear: cash on deposit pays virtually nothing, ageing populations are in need of income, and European equity dividend yields are at near-historic highs versus very low government bond yields. However, this merely explains the demand for income. The empirical success of dividend investing over time illustrates, in part, the incredible mathematical power of compounding (from the reinvestment of dividends over a cycle), which is in itself a potent argument for a high-yield strategy.

In our view, the reason why dividend-paying companies outperform over the long-term is much more intangible and subtle; investing and managing companies is, after all, more art than science. By obliging a company to generate cash for distribution, management must forgo exploiting every possible growth opportunity, which imposes the discipline of maximising those good growth opportunities that exist. This is the paradox of yield: constraining the available capital helps improve a company's long-term, profitable growth.

History abounds with wasteful acquisitions and deluded growth strategies. Management is forced to ration capital and to rationalise every decision, and management egos are subjected to the demands of shareholders. The proof of success is in a company's ability to pay an increasing dividend year-in, year-out.

To investors, we believe that the importance of profit realisation in the form of dividends is paramount, as it forms a source of income which is independent of the price of the stock itself, and is available without necessitating sale of the stock. Share buy-backs might work in theory, as they are certainly more tax efficient, but very few companies bought back shares in March 2009 when this would have created exceptional value for shareholders. Often when a company has the confidence to buy back shares, the market is also exhibiting confidence, and the shares are likely to be valued at a high price.

It must be tempting, looking at the performance of equities since the financial crisis, to throw money after those risk stocks that might double or treble in value. What good is it to stay in those dull, well-capitalised companies, with competitive advantages and solid cash flows?

Lottery investing can be quite enjoyable and, if the trade winds are blowing the right way, can pay off spectacularly; that oil exploration company, for example, might just strike it rich off the coast of the Falklands. But remember the lesson of the Dutch all those years ago: package risk and divide the rewards; pay out some money to shareholders and retain some for growth. If this is done consistently, gradually paying out a little more over time, then the company should prosper. In short, we do not believe it is wise to extrapolate the dramatic re-pricing of 'risk assets' since the credit crisis.

We remain convinced that an income-focused approach to investment in Europe will generate attractive long-term returns.