In spite of the more positive tone to the equity markets during the past few months, institutional plan sponsors and their advisers increasingly realize they face real structural impediments to the average 7% to 9% return assumptions built into their asset allocation models.
Everywhere they look, challenges abound. Growth in developed markets is scarce and is likely to remain so for an extended period of time; bond yields remain at historic lows and as we have seen recently, likely have upward bias over the longer term, tempering future return assumptions for fixed-income allocations; and high correlations and recent poor performance make hedge funds and other alternative investments less differentiated in their return profiles.
This environment requires a fundamentally different way of thinking about asset allocation, one where selectivity is paramount and income is increasingly valued. On the equity side, investors are increasingly looking at high dividend yields as a way to supplement the low yields of fixed-income investments and potentially mitigate recent high levels of equity volatility.
It is hard to dispute the logic of wanting to invest in companies whose cash-flow generation allows them to regularly pay out a generous dividend. The problem is that focusing on dividend yield is a backward-looking exercise that does not take into account the growth prospects of companies; it does not factor in their ability to continue to pay dividends. When investing in equities, it is far more important to focus on dividend growth than on dividend yield.
The benefits of this approach are significant. Over the past 10 years, companies with the highest dividend growth within the broad S&P 1500 index outperformed those with the highest dividend yield but the lowest dividend growth by more than 120 percentage points, a gain of 159% for the former compared to a gain of 36% for the latter. The results remain unambiguous even when one excludes companies that sharply reduced or stopped paying dividends. Companies with the highest growth in dividends outperformed those with the highest dividend yield and low but positive dividend growth by more than 40 percentage points during the same period (159% vs. 116%). The difference is even more striking for global equities. During the same period, global companies with the highest dividend growth were up 232% while global companies with low but positive dividend growth rose only 60%.
In an environment where slow growth is likely to remain a defining characteristic, at least in developed economies, finding companies that have high prospects for strong dividend growth requires focusing on certain characteristics: 1) the sustainability of a company's revenue and earnings growth; 2) the cash productivity of the business; 3) the amount of debt on the balance sheet; and 4) the dividend payout ratio.
In other words, high future dividend growth rates are more likely to come from companies with strong, consistent growth in revenues and profits, business models that convert a high percentage of earnings into free cash flow, low levels of debt and meaningful potential upside to the current payout ratio.
While many companies were able to cut costs dramatically during the 2008 recession, aggregate operating profit margins for the S&P 500 of 8.6% are now back to the peak level reached in 2007 and well above the 5.4% average of the past 50 years. Going forward, profit growth will require revenue expansion, a far more difficult challenge. In addition, businesses must also be able to generate sizeable free cash flow to be able to return it to shareholders.
Finding these companies is not easy, but they do exist, both in the United States and internationally. What characteristics do they share? They tend to have pricing power, recurring revenues and large market opportunities to grow into. They convert a large proportion of their earnings into free cash flow. They are generally self-funded and carry little or no net debt, so they have few structural obstacles in the way of higher dividend payments. In spite of economic and regulatory uncertainty and the current tax burden imposed on repatriating cash from overseas, they have on average grown dividends at more than 10% annually over the past five years. This compares to annual dividend growth for the S&P 500 of -4% over the same period. What's more, the current dividend payout ratio of these companies is only 21%, below that of the S&P 500, so the prospects for dividend growth are high.
It has been estimated that the U.S. faces a total underfunding of private and public pension liabilities well in excess of $2.5 trillion and rising. It is our view that the broader equity market in general is unlikely to be able to generate the types of returns that would enable investors to meet future payouts. Factor in the potential risk to capital when interest rates begin to rise given the large allocations to fixed income from investors grasping for absolute dollar income levels and the challenges get magnified.
We believe a potential solution to those challenges is to invest in a select group of high quality businesses benefiting from faster growth, strong cash generation and pristine balance sheets. Those businesses offer a very attractive return potential based on valuation. In addition, these select companies are likely to return increasing amounts of the strong free cash flows they generate to shareholders resulting in rising dividend yields over the years to come. If history rhymes, this should be a solid option to provide investors strong absolute and relative returns with a growing income stream, and should contribute to closing the pension funding gap.