Global equity income
Stocks that pay good dividends can trade on expensive valuations. What types of equity income stocks in which areas should be able to provide a good income for a reasonable valuation in the near future?
Dan Roberts, manager of Fidelity Global Dividend (GB00B7778087)
Global equities have raced to all-time highs in 2021, but the economy is now at a potential transition point as pandemic-related fiscal and monetary support measures start to wind down. In particular, the positive earnings revisions that have buoyed the market of late are unlikely to be sustained into next year as growth moderates and input cost inflation takes hold.
High-quality companies that benefit from pricing power and resilient demand for their products should be well-placed against this backdrop. Many such companies have fallen out of favour this year as investors have sought high-growth digital winners or more cyclically exposed sectors such as energy and banks. So, as we look forward into 2022 and beyond, the risk/reward offered by defensive dividend growers looks particularly attractive.
After a year of such strong earnings revisions in 2021, it would be a shock to most market participants if earnings fell in 2022. Such a scenario may seem unlikely, but is not impossible. At the operational level, margins are being pressured by inflation in commodity and transportation costs, and the tightness of labour markets is starting to lead to an increase in wages. Tax rates are also likely to rise as governments look to fund their fiscal expenditure. Together, these headwinds could make it tough for companies to grow their earnings significantly from current levels.
Some defensive sectors have seen muted earnings growth in 2021 as gross margins have been pressured by input costs, and corresponding pricing action has been implemented with a lag. But as that pricing comes through next year and the rate of increase in input costs slows, these businesses could post healthy profit growth in 2022 against a backdrop of more muted progress or even declines elsewhere.
Consumer staples is a particularly high-conviction area of the Fidelity Global Dividend Fund. Apathy towards defensive sectors and poor short-term earnings revisions in the sector have led to deratings. These provide an attractive valuation opportunity in high-quality businesses that we would look to own over the long term. Non-life insurers also continue to play a key role in the portfolio. Our holdings provide attractive dividend yields backed by defensive cash flows, with low correlations to the economic cycle.
One of the key themes we continue to monitor is government intervention, particularly among more heavily regulated businesses such as utilities and in other sectors that are under political scrutiny, such as pharma or big tech.
The fund does not invest in parts of the market that are incompatible with our investment approach. For example, we are absent high-growth areas such as software on the basis of stretched valuations and sentiment. And we are under-represented in banks and commodities on quality grounds – many companies in these areas exhibit low levels of earnings visibility and high levels of gearing.
UK equity income
With potential headwinds such as the Omicron variant, Brexit, rising inflation and possible interest rate rises, what areas and types of UK companies might be able to hold up against potential challenges and offer a good income in the foreseeable future?
The list of potential challenges may be quite long and, if anything, I am even more cautious than many others as I believe the Chinese slowdown is structural in nature. As it has been at the cornerstone of global growth, this implies that the trajectory of global growth might be quite muted in the future. I also assume that the upwards pressure on wages will persist and, if it does, many businesses could be faced with a combination of limited growth and margin pressure.
The stocks that are best-placed to resist the margin pressure are likely to be those of companies that are delivering outstanding customer service. The pressures will be so severe that 'good' won’t be good enough. We look for management teams that have been actively stretching to keep up to date with the problems of their front-line staff,such as with regular staff surveys. And we look for evidence that they take the results seriously, for example do the results form part of the board paper? These businesses won’t be immune to the pressures, but at least they are in a position to push back if customers ask for price reductions.
We have always equated sustainable dividends with companies that are set to generate plentiful cash after some years of heavy investment. So we tend to select the stocks of companies that are coming to the end of a long period of investment, where the scale of the potential surplus cash flow is overlooked. As they succeed, they tend to get more recognition from the stock market, so their share prices often appreciate alongside a period of good dividend growth in the best cases.
Diverse Income Trust holds stocks with what we believe to be these characteristics and that we anticipate have the potential to continue to drive good performance in the coming years.
It has been difficult to get a good yield with bonds offering low or even negative yields. Is this situation set to improve and how will you generate a good income going ahead?
Ariel Bezalel, manager of Jupiter Strategic Bond (GB00BN8T5596)
Low yields are here to stay. A combination of excessive debt and worsening demographics will keep inflation, growth and interest rates pinned at low levels. Real rates – interest rates adjusted for inflation – have been deeply negative in the UK since 2011, in Europe since 2014 and in the US since 2020. Every time we see modestly higher real rates we get market turmoil and easier policy. The global economy cannot tolerate a meaningful shift higher in yields.
But that doesn’t mean we can’t construct a portfolio that gives decent levels of yield for a reasonable level of risk. Loose policy will continue to suppress default rates, allowing us to continue to earn a decent income from high yield. The key is firstly to have a broad toolkit, enabling us to go anywhere across fixed income. For example, while we prefer developed market high-yield to emerging market credit at the moment, we can dynamically allocate as conditions evolve.
Secondly, in this environment there is a huge advantage in 'bottom up' active credit selection, only investing in names and sectors that we like.
And the yields available on sovereign debt in China, the US and Australia, while low relative to history, look pretty attractive on a risk-adjusted basis. A decent yield is still available if you can build a diversified portfolio and adjust your allocation dynamically as markets evolve.
Has it been harder to get a good yield when investing via ethical constraints and how will you generate a good income going ahead?
Noelle Cazalis, co-manager of Rathbone Ethical Bond (GB00B7FQJT36)
Fixed-income investors with ethical constraints face the same challenges as those without: government bond yields have been declining, so the income that investors get from newly issued bonds is lower than it was several years ago.
However, there are ways for us to maintain our income. We buy bonds in the secondary market. Some of these bonds were issued in difficult market conditions or when yields were higher, so carry a higher income than newly issued bonds. In particular, this applies to bonds in the subordinated insurance space to which we had a 36.6 per cent allocation at the end of October. And we continue to like this sector: fundamentals have remained strong despite the pandemic, and valuations remain attractive when compared with the rest of the investment-grade universe.
Development of green, social and sustainable bonds has evolved significantly. As the market becomes more mature, we see an increasing range of issuers. For example, we have seen more BBB-rated issuers which offer investors with ethical constraints more investment opportunities in higher-income bonds. Renewable energy companies are now issuing hybrid debt. These include Vattenfall, which issued its first sterling green hybrid bond in June 2021 and this carries an income of 2.5 per cent. Following on from the 2021 United Nations Climate Change Conference (COP 26) and the issuance of green gilts by the Treasury, we expect more sterling issuance of that sort.
Overall, Rathbone Ethical Bond Fund continues to have one of the highest income yields in the Investment Association Sterling Corporate Bond sector. As of October 2021, it had an income yield of 3.24 per cent – higher than the sector average of 2.27 per cent.
With Covid-19, rising inflation and a great deal of uncertainty ahead, how can global equity investors select companies that should still deliver growth over the long term? Do any particular types of stocks, sectors or regions look as though they have good prospects?
James Thomson, manager of Rathbone Global Opportunities (GB00BH0P2M97)
The global economy was hit by the summer surge in Covid and some inflationary pressures look persistent. But a modest pullback from peak growth does not mean that a deep slowdown is imminent. The economy and stock market could well stay skittish, while grinding higher because the employment picture is so healthy, inventories are low, consumer savings are high and capital expenditure has still not caught up with demand.
That said, investor sentiment has got more fragile as we’ve hit many economic, monetary policy and political inflection points. This has caused abrupt changes in market leadership and amplified stock market moves. Investors keep churning between reflation, stagflation and resilient growth stocks with alarming inconsistency. Factor and style shifts blaze up quickly and then burn themselves out. Many companies have suffered recently as rising operating costs, product shortages and delays have hit demand.
As we go into 2022, we’ll still be in a world of unreliable growth. But we believe that the worst of the supply chain disruptions will be behind us and the bar will be lowered in terms of earnings expectations. Recent surveys indicate that companies with pricing power plan to increase prices by significantly more than they plan to raise wages. If these price rises stick and sales volumes remain robust, this could deliver some explosive earnings upside even though the journey towards them will be bumpy.
Our key exposure is to the US, because that’s where the growth is. US companies are growing profits more than four times faster than the rest of the developed world and many of those competitive advantages are permanent.
Many of these growth stocks in the US deliver higher top-line revenue growth, but it’s resilient and much less sensitive to changes in economic growth. Often, these businesses have high levels of recurring revenues – long-term, repeatable, subscription-like cash flows housed within asset-light shells. And where the intrinsic value of the business is built on high confidence in decades of sustainable growth – long-duration assets.
Growth investing does well when widespread reliable economic growth is hard to find. Twenty years ago, almost half of S&P 500 index companies were growing their revenues consistently more than 15 per cent a year. Today, only 70 out of 500 companies are doing that. This means that returns could be concentrated in just a handful of companies that are providing this growth and most of them are in the US.
Should investors allocating to the US avoid large tech stocks as these have had a very good run that cannot go on forever? What areas in the US should they consider allocating to?
Large tech stocks have had a good run, but the best of them remain attractive. Their gains simply reflect enviably high levels of profitability, and the sustainability and strength of their cash flows.
These stocks still have the potential to outperform. But we must be careful to draw a distinction, as there is also a significant cohort of tech stocks that have performed well despite their generally uninspiring fundamentals. I’m thinking of profitless stocks and those trading on high projected earnings multiples which could find 2022 a less forgiving environment.
There is, of course, a lot more to the US market than tech and – lest we forget – opportunities beyond megacaps. Within technology, we also find attractive opportunities among small and mid-cap software stocks. If they have the right products, they should be able to generate strong revenue growth while maintaining profitability. But it is an ‘if’ – careful analysis is needed here. There is also the possibility that they prove to be interesting [takeover] targets if megacap companies decide to buy their technology rather than build it themselves.
This feeds into a wider theme – opportunities in the small/mid-cap parts of the US market. This is an area that tends to be less exhaustively researched than large-caps, creating opportunities for diligent active investors. With prospects for continued strong growth in the US economy, investors might want to look at more US-focused companies, and these are often found in the small and mid-cap parts of the market. Companies exposed to US consumers appear to be particularly well-placed: ratings agency Moody’s estimates that Americans have accumulated over $2tn of excess savings through the pandemic.
Victoria Stevens, co-manager of Liontrust UK Micro Cap (GB00BDFYHP14)
UK companies have had to contend with challenges such as Brexit and the pandemic, and now face further headwinds such as rising inflation. Which ones look best-placed to ride these out and continue to deliver growth?
Companies in most industries and sectors have been exposed to the economic frictions that have arisen during the economic recovery from the pandemic and associated lockdowns, most notably wage cost inflation and supply chain problems. The companies in our funds have also been affected, but we are confident that our investment process steers us to the type of company that is most likely to withstand these issues. These are companies with strong barriers to competition, attractive market positions and a history of high returns.
One of the key benefits we believe durable competitive advantage confers is pricing power. A company with true pricing power can pass on some or all cost inflation rather than having to absorb it through a reduction in profit margins, and this looks set to be a key attribute as we enter 2022.
Another key post-pandemic trend for the year ahead is likely to be an acceleration in the digitalisation of the economy. The shift to digital is one that affects pretty much every company in every sector, both positively and negatively. We think that this will be a tailwind to the growth of many of our smaller and microcap companies that have technology at the heart of their businesses.
With headwinds such as the Omicron variant, rising inflation and possible interest rate rises, how can you find the companies best-placed to deliver growth?
David Walton, manager of IFSL Marlborough European Special Situations (GB00B90VHJ34)
While new Covid variants, higher inflation and the prospect of interest rate rises all require a high degree of vigilance, we’re continuing to see attractive opportunities among European companies. We’ve been using share price declines caused by what we believe to be short-term concerns to top up our positions in companies with strong long-term prospects.
We don’t invest in a stock because we favour particular countries or sectors. Rather, we identify individual companies that meet our criteria, which are pretty exacting. We’re looking for businesses with quality managements and above-average growth potential, trading on what we believe are cheap valuations relative to their prospects.
So we’ve been adding to our holdings in companies in a diverse range of sectors, from market research to semiconductor manufacturers. France has overtaken Sweden as our largest single-country exposure, at around 18 per cent of the fund, but that’s down to us seeing opportunities in individual companies rather than making a call on the French economy. It’s also because several of our French holdings have had a strong run.
“We have a strong bias to small and microcap stocks because many of them have significant growth potential. But they’re ignored by most investors simply because of their size.
The companies we’re talking to aren’t expecting any significant easing of inflationary pressures caused by the higher cost of raw materials, components, labour and energy in the medium term. However, because demand is strong, many companies have been able to pass these higher costs on to their customers. That’s particularly true of the businesses we tend to favour – smaller companies operating in niche markets.
So while we’re far from complacent, we believe that the picture for European companies looks encouraging, with solid demand and likely sales growth in 2022. Some businesses face uncertainty on profit margins due to higher costs, but for quality companies with strong management teams the outlook is positive.
Japanese equities have looked relatively cheap versus other developed markets. Why, and can they still provide growth? What areas of this market and types of companies offer the best growth opportunities?
Nicholas Price, manager of Fidelity Japan Trust (FJV)
We remain broadly positive on the outlook for the Japanese market as we move into 2022. Valuations remain supportive and compare favourably with those in other developed markets such as the US, while earnings momentum is strong.
A delayed recovery in the manufacturing sector due to Covid-19 restrictions and supply disruptions means that some of the earnings recovery has been pushed into the first half of 2022. While there was some weakness in the first half of the 2021 fiscal year, we expect corporate profits to be quite strong in the first six months or so of next year. The outlook for the second half of 2022 is less clear, with the potential for interest rate rises, so we are looking at business-to-business companies and moving away from consumer-related names and those that have benefited from strong pricing this year.
As recent headwinds to earnings, notably supply constraints, raw material costs and freight rates, fall away and start to reverse, we could see a decent uplift to earnings in the first half of 2022. But a potential negative is high and rising energy prices leading to an economic slowdown globally.
As supply constraints ease, consumer-related companies will see a peaking-out in margins and, as we move towards the second half of 2022, a lot of the pent-up demand will have played out. Against this backdrop, we are looking at long-term winners that can grow sustainably. This includes companies with strong positions in growing markets such as factory automation and software services, those with new product cycles and those implementing environmental, social and governance (ESG) and structural changes.
In particular, we like efficiency enablers in the manufacturing and software sectors [that are helping companies to improve this via] factory automation, digitalisation or software-as-a-service. Over the longer term, we are looking at companies that can contribute to and support Japan’s energy transition and the requirements for energy efficiency such as green energy and electric vehicle components.
At the same time, a gradual loosening of supply bottlenecks means that the pricing environment will become less favourable for many companies. As products become more widely available, pricing will shift downwards. So we favour companies that are not directly consumer-facing and are avoiding manufacturers that may face pricing pressures as supply constraints ease.
Our high-conviction ideas tend to be where we have a differentiated view to the market on a company’s mid-term growth prospects. The largest overweight positions in the fund are companies that are efficiency enablers that can generate sustainable growth.
By contrast, financials in Japan continue to face structural headwinds and we are generally underweight in that area of the market. We are also avoiding companies that benefited from short-term bottlenecks and with sluggish mid-term growth prospects.
With tightening legislation on companies in China, should equity investors avoid stocks listed on its markets or companies that do most of their business there? Where in Asia offers good long-term growth potential?
The recent [Chinese] regulations, which may have been driven partly by the government’s concern for the rights of employees, workers and small businesses, are nonetheless aimed squarely at the dominant companies in their sectors. It is not uncommon for governments globally to start to take measures or implement regulations when companies become too big and crowd out competition.
These regulations can be seen as cyclical, and the relationship between regulators and investors is likely to be interactive. Governments may adjust regulations after observing the market’s response, as capital-raisings are important for the health of the whole economy.
This situation provides a buying opportunity for long-term investors in Chinese equities. If the share price of a company has fallen while the fundamentals remain unchanged, the valuation has become more attractive providing a better risk-reward opportunity.
We like innovative companies that are able to leverage technology to improve their products and services. The investment case for Chinese innovation and technology is still intact – there is more to it than just internet platforms or ecommerce sites.
The sheer size of the market in India provides opportunities to invest in high-quality businesses across a range of industries. These are companies with good governance and run by families who think in terms of the long term and are fully engaged and focused on delivering attractive returns on capital. Also, market penetration rates in most categories in India are still very low. In segments such as biscuit consumption, vehicles or air-conditioners, most of the market leaders are small companies with decades of growth left.
How can you avoid companies that will be negatively affected by new Chinese controls? How do you pick companies that should still offer growth over the long term?
Dale Nicholls, manager of Fidelity China Special Situations (FCSS)
It is important to be cognisant of the long-term goals laid out in policy documents such as the current Five-Year Plan when assessing how the regulatory landscape could change and impact an industry’s growth profile.
Reigning in property speculation is a crucial aspect of President Xi Jinping’s vision of a more equal society. While it is likely that we will see some developers default, I think that the systemic risk remains low. And one should not be surprised to see some policy fine-tuning in the near term as both property and land sales continue to slow down. We are already seeing signs of accelerating mortgage approvals in some cities.
But an underweight real estate exposure, coupled with an overweight position in the healthcare space, has benefited Fidelity China Special Situations’ overall performance. Within healthcare, an overweight position in Wuxi AppTec (CHI:603259) supported returns. While we need to be concerned over pricing pressures in the generic drug sector, the continued emphasis from the government on developing the innovative drug sector remains very much intact. Wuxi AppTec is a key facilitator in this area. And the prospects for China establishing itself as a global hub for innovation in drug development should gain traction.
I remain positive on the outlook for life insurance with regard to rising penetration over the mid term. Near-term fundamentals generally remain tepid, but this is more than factored into what remain very attractive valuations. While I remain underweight the banking sector, I have built a position in Postal Savings Bank of China (HK:1658). I believe that it is undervalued given its strong, growing position in retail banking and wealth management, which is helping to drive superior returns relative to the sector.
After the significant recent correction in technology-related names, I feel that the risk/reward payoff is now tipping much more in our favour regarding these companies. While there is still risk of new regulation, there's a good chance that we are near or close to a peak in terms of newsflow. The government has ambitious long-term goals in areas of economic development and innovation which will be difficult to achieve without a vibrant private sector. And valuations for many companies have moved to historical lows and look even more compelling compared with global peers.
I also continue to feel positive about the outlook for the unlisted portion of the portfolio. This includes new holdings Tuhu Car, the number one brand for independent auto aftermarket products and services in China; Cutia Therapeutics, an emerging leader in the dermatology and medical aesthetics space in China, and Beijing Beisen, a first-class human resources management software company. It is a market leader due to its superior cloud and integrated solutions for talent management.
Austin Forey, manager of JPMorgan Emerging Markets Investment Trust (JMG)
Can active investors find individual companies in emerging markets that look well-placed to deliver strong growth over the long term? In what areas can they find them and what types of companies can deliver such growth?
The long-term structural story for emerging markets, driven by the emergence of the middle class and consumer demands, hasn’t changed. As the world adjusts to the new normal ways of living, pre-existing structural trends in emerging market equities will continue to accelerate. These trends include strong companies continuing to grow and develop market share, increased shareholder prioritisation and greater investor focus on corporate behaviour relating to stakeholder and employee concerns. We look for exposure to companies with sustainable competitive advantages, consistent cash flow generation and strong management teams.
Emerging markets are becoming more like developed markets, in the sense that the value creation in the corporate sector is being strongly driven by similar factors. Digitalisation, the development of internet-based business models and the creation of intangible value rather than reliance on physical assets, are far more widely seen in emerging markets today than in the past. The majority of JPMorgan Emerging Markets Investment Trust’s portfolio is invested in sectors that broadly fit this characterisation: software services, internet services, gaming, consumer brands and stock exchanges.
We see these characteristics in companies across the breadth of the asset class. For example, MercadoLibre (ARG:MELI3) is Latin America’s leading ecommerce platform with almost a third of the region’s population registered as users. Much of MercadoLibre’s current growth is thanks to its e-wallet product, MercadoPago. We are also particularly positive on the outlook for Latin American software development company Globant (ATG:GLNT3) which provides services to major western corporations such as Disney (US:DIS), Google (US:GOOGL), LinkedIn and Coca-Cola (US:KO).
Overall, to harness opportunities in emerging markets, it is key to take an active, bottom-up approach. Investors should consider the growth potential of specific companies rather than taking a view on individual countries. Economic fundamentals and corporate skills are the most important determinants of long-term investment outcomes, as opposed to the overall performance of individual markets. While we are continuing to monitor the newsflow on the Omicron Covid-19 variant, at this stage it is too early to suggest that it changes our broader outlook on the long-term growth opportunities in emerging markets.