AI can deliver to the corporate bottom line and therefore to their clients’ investments.

Investing in long-term growth strategies means having a positive outlook on the future. It also means believing that some companies will outperform their peers in terms of revenue and profit in the coming years. You are also investing in the company’s ability to adapt and utilise new technology opportunities to enhance their products and services as time progresses.

One way to show optimism is via the re-investment rate. This has three forms (1) Capital expenditure, such as new factories, shops, server farms (2) Acquisitions, such as purchasing a competitor, supplier or (3) Research & Development, such as new products or services, new methods of production. This paper mainly focuses on understanding the output of the third factor, R&D, and in particular the investment in artificial intelligence (AI).

R&D is the home of innovation for any business. With the emergence of AI, this has the potential to create revolutionary new products and services and make companies more efficient, thus leading to higher levels of growth and ultimately higher total return for your clients.

To date, stock markets have largely rewarded the ‘manufacturers’ of AI – the technology firms who have created the capability, including semiconductor firms (Nvidia, ASML, Applied Materials), hosting firms (Microsoft, Amazon) and software firms (Microsoft, Meta, Alphabet). However, technology firms are not the only story. Many firms outside technology are using this capability today and on a path to likely building the amazing products and services of the future. Let’s call them the ‘practitioners’.

This paper aims to provide insights that to capture the productivity gains that AI will certainly offer, it will not only be the ‘manufacturers’, often on higher valuations, but the ‘practitioners’ who will benefit in the years to come.

If you arrived on Earth from Mars in 2023, and were interested in stock markets, you may be forgiven for thinking that Nvidia owned all the rights to AI! For simplistic clarification, they don’t.

Investing in growth businesses using AI will likely be good for returns. Diversification is important.

How should advisers assess long-term returns?

Equity returns are difficult to assess. On one level they are easy – ‘what was the total return?’ and ‘did it beat its peers?’. When looking a little deeper, topics such as style or volatility are added to provide a clearer picture of assessing ‘was this good?’ and ultimately ‘is it likely to be repeatable?’. I would like to offer some analysis that was conducted by an industry leader.  The analysis was focused on what drove equity returns over short and long periods to understand some of the ‘forces’ behind the numbers.

Over short-term periods of one year, the fundamentals account for around a half of the total return. The other half is valuation, representing the market trying to price the anticipated gains. However, over long periods the valuation component subsides and lets the companys’ actual business performance be the dominant force. They used Dividend growth as the measure for that growth and dividend yield as the measure for the payment back to shareholders, which for the study was assumed to be reinvested.

It showed growth to be the largest factor – but what drove the growth? Every manager should be able to identify the source of the growth. Most often it is reinvestment that feeds profitable revenue growth. If a strategy has done well with most of the return coming from valuation gain, then an element of correction is more likely.

Will AI affect returns?

Many reputable organisations have made forecasts on how AI will affect the global economy, and although the numbers vary, they all agree that there will be significant productivity gains. The McKinsey Institute estimate that generative AI alone will add between $2.6tr and $4.4tr per year, a figure equivalent to between 2% and 4% of global GDP. For comparison, this is bigger than the combined UK & Australian GDP, or the entire automobile industry. And unlike these economies, which took a long time to grow to those levels, AI is expected to do this in less than a decade.

This will likely play out, as it always does, differently over short and long-term periods. The short-term will have some valuation exuberance as market react to company’s prospects, we have certainly witnessed this with many of the technology companies. It is likely though that the longer term will be driven by the fundamentals. This favours a ‘buy and hold’ manager who is confident in the underlying business.

The new industrial revolutions – where is AI being deployed?

1. Computing

The Semiconductor Industry Association (SIA) has forecasted that their industry will reach U$1tr in revenues. The chart below displays this mix of real and projected growth in terms of eras of computing, emphasizsing the main improvements. We are clearly in the fourth era now.

Please note in the chart the steepness of the line once in era 4. The pace of change is increasing.

Also sourced from the SIA, is the analysis of demand for semiconductors in 2022, highlighting the areas of growth. Although, communication and computers have the largest demand, they have the slowest growth, a suggestion that demand is shifting from the ‘manufacturers’ to the ‘practitioners’.

Past performance is not indicative of future performance.

2. Industry 4.0

Industry 4.0 refers to the integration of digital technologies, such as artificial intelligence, cloud computing, big data, and the Internet of Things, into the manufacturing processes and products. Industry 4.0 aims to create smart factories that are more efficient, flexible, and responsive to customer needs and market changes. Industry 4.0 also enables new business models and value propositions based on data-driven services and solutions. The following image illustrates some of the key components and applications of Industry 4.0.

This transition is in many factories throughout the world are well under way and will hope for significant manufacturing capability.

3. Retail channels

Retail has shifted from traditional brick-and-mortar stores to omnichannel platforms that combine physical and digital channels. Omnichannel retailing allows customers to interact with brands and products across multiple touchpoints, such as online, mobile, social media, or in-store. Omnichannel retailing also enables retailers to collect and analyse customer data, personalize offers and recommendations, optimize inventory and logistics, and enhance customer loyalty and satisfaction. The following image shows some of the benefits of omnichannel retailing for both customers and retailers.

What is the significance of this? In a world where only physical stores exist, a customer would enter a store, pick an item, usually pay with cash and leave. The merchant would have little or no information about who they were, why they bought the item, what else they might be interested in buying, and how they would stock the store to match the general needs of the customer.

In contrast, in an Omnichannel world, they would likely know the customer, their preferences, their motivations, their past purchases and possibly their future purchases. They achieve this by engaging with customers digitally through social media, email and registration, which gives them the ability to create a service rather than a container for selling products. This affects what products are offered, to whom and how stores should be arranged. This allows retailers to move from ‘for all’ to ‘for each’. More efficient, more brand value and more satisfied customers.

For instance, L’Oreal, the biggest beauty company in the world, provides ‘Phygital’ services. One of these services is a product from Giorgio Armani, Meta Profiler, which uses an AI powered camera to give a scientific analysis of skin to recommend the best products to use. This would happen in-store and let the customer buy the chosen products online or in the shop.

As David Ogilvy, the founder of the Ogilvy advertising agency, once said, “The problem with market research is that people don’t think what they feel, they don’t say what they think and they don’t do what they say.” The emergence of AI and machine learning is beginning to address the limitations of focus groups and surveys to analyse consumer behaviour. Think of the influence of Cambridge Analytica and its ability to interpret who people were and their likely political views and deliver content to change voting patterns, very powerful and also ethically questionable. Retailers now have this power at their disposal to engage much more deeply and get closer to those ‘feelings’ that Mr Ogilvy mentioned.

How will this affect returns?

Below is a depiction of some of the companies and their AI powered products that are providing health, wealth and happiness to the world.

The following sections of this document will describe some of these products in further detail. All text in italics denotes the words of the companies.

Heath – Novo Nordisk, a ‘culture of innovation’

Danish healthcare giant supported by the century old Novo Foundation. For a long time, this firm has been involved in some major treatments for the world. They have done groundbreaking research and then delivered products that address the world’s big health challenges. They clearly have a strong culture of innovation.

The firm is known for its diabetes treatments. Then they looked at the causes of the problem they were treating, mainly obesity, and launched the very successful weight loss drug, Wegovy. Now they are studying more aspects of cardiovascular disease.

Novo Nordisk are using AI throughout their whole business as shown below from research & development, through clinical development, product supply and sales activity. Their parent back, the Novo Foundation have collaborated with the Danish government and Nvidia to create one of the world’s largest super computers to allow AI research and development into the world’s largest health problems.

Recent specific analysis has been pointed around identifying cardiovascular risk in patients to ultimately to reduce life threatening heart issues.

Revenues for the firm grew by around 25% per annum, dividend growth by a similar number. The level of reinvestment coupled with a ‘culture of innovation’ will likely see this firm continue to grow strongly.

Stryker, robotics revolutionising joint treatment

US based healthcare firm who provides robot arm surgery on joints – knees, hips and shoulders. Their Mako robot has been assisting surgeons for 18 years and have delivered more than 1 million surgeries globally. AI is embedded in the product. Definition below is taken from the Styker website.

Let’s talk Mako SmartRobotics

Mako SmartRobotics combines three key components: 3D CT-based planning, AccuStop haptic technology, and Insightful Data Analytics, into one platform that has shown better outcomes for your total knee, total hip and partial knee patients.

Mako Total Knee

The unique features of Mako Total Knee SmartRobotics are designed to help you optimize Triathlon component positioning and enhance functional outcomes.Intraoperatively, surgeons have the ability to assess soft tissue laxities and adjust the placement of implants to achieve the final position before cuts. With the use of AccuStop haptic technology, studies have demonstrated more pristine bone resections, less soft tissue damage and greater bone preservation when compared to manual cutting blocks.

Mako Total Hip

Enhance your Mako Total Hip experience through patient-specific planning to enable more accurate implant positioning to plan.6 Surgeons can visualize potential impingement by looking at the changes to their patient’s pelvic tilt in the sitting, standing and supine positioning. Using AccuStop haptic technology and a patient specific CT scan, Mako Total Hip enables single stage reaming and guided cup impaction to help promote accurate implant placement.

Insightful Data Analytics

Know More. Keep score. With Insightful Data Analytics.

Can you really know you’re getting better if you’re not keeping score? Mako SmartRobotics Insightful Data Analytics helps you create, analyze and track a scorecard of the things you want to improve most, like surgical time, turnover time, complications and readmissions. The program also includes a platform designed to drive engagement with your patients throughout their episode of care and automatically collects patient-reported outcomes so you can efficiently track their progress.

This technology has been a breakthrough for many people’s lives providing effective surgery. It is also a successful product for Stryker, growing 10% per annum over the past 4 years, the growth in the annual dividend grew by around the same amount.

Wealth – Visa, reducing fraud

Fraud detection is an enormous world problem. According to analysis conducted by Nasdaq it is around %0.5 trillion a year, with money laundering & illicit flows a further $3.1 trillion. AI is at the heart of reducing this number and keeping customers safe. In the words of Visa below, further analysis is provided.

On any given day, Visa processes hundreds of millions of transactions.

Whether you’re buying coffee, shopping online, or paying for the subway, our system processes that payment information, routing it among parties, authorizing transactions and managing risk all in the blink of an eye.

Every second, up to 76,000 transactions travel across more than 200 countries and territories, on a platform built on more than 300 million lines of custom code and more than 24 million route miles of private network. In the last 12 months, that platform processed $14.5 trillion in total payments volume.

An integral part of this operation, for more than 30 years, has been artificial intelligence.

Back in 1993, Visa became the first network to deploy AI-based technology for risk and fraud management, pioneering the use of AI models in payments.

Over the last 10 years, Visa has spent more than $3 billion on AI and data infrastructure to enable the safer, smarter movement of money and to proactively identify and prevent fraud.

And today, our technology platform is among the most powerful examples of the tangible benefits of AI.

With several hundred AI models in production, powering over 100 products, our AI and deep learning capabilities help to solve longstanding challenges and pain points for buyers, sellers, and financial institutions.

For instance, products like Visa’s Cybersource Decision Manager, a fraud and risk assessment tool, apply advanced machine learning to historical transaction data to spot patterns. At our Risk Operation Centres, AI-enabled capabilities and always-on experts protect Visa’s ecosystem, proactively detecting and preventing billions of dollars in attempted fraud. And Visa’s real-time deep learning model, Smarter Stand-In Processing (STIP), helps improve payment experiences during outages by mirroring issuer approvals with up to 95% accuracy. And in 2022 alone, Visa’s real-time payment fraud monitoring solution, Visa Advanced Authorization (VAA), helped prevent an estimated $27 billion in fraud.

Visa’s revenue has grown by low double-digit growth over the last five years. Removing fraudulent activity will continue to make this firm profitable.

Beauty – L’Oreal, ‘Beauty for Each’

The largest beauty firm in the world. AI has been used through each of the business areas and in particular to gain better understanding and servicing their customers through an omnichannel approach.

Below are some of their AI products in their owns words (in italics).

1. HAPTA from Lancome – Luxe

Since 2009, Lancôme has been empowering women with the most personalized solutions powered by next-generation beauty tech. As part of its mission to use tech for good and make beauty accessible for all, Lancôme continues to set the pace of innovation with HAPTA.

Bringing the science of touch to women everywhere, HAPTA is designed for those with hand-motion disorders, arthritis, Huntington’s Disease, and following stroke-related motion challenges.

This motion-stabilizing device harnesses the power of technology to assist those who have difficulty raising their arms due to limited mobility issues, and people with limited grip strength who struggle with precise application. It also helps anyone with limited wrist mobility who may find it difficult to get a comfortable angle when applying lipstick or mascara, as well as those experiencing tremors and a lack of sensation in the hands.

Unveiled for the first time at the Consumer Electronics Show 2023 in Las Vegas, Nevada for the application of lipstick, HAPTA is enhanced with new features to also works for mascara application, two of the most common forms of self-expression through beauty.

As a Beauty Tech premiere, HAPTA makes the expression of beauty more accessible, more achievable, and easier than ever before.

AI is used to allow this product to learn from your movements. Life changing technology enabling a level of independence for people throughout the world.

2. Giorgio Armani Meta Profiler – Dermatological

DECODE SKIN IN HIGH-PRECISION

Imaging skin with 10 times the magnification of the human eye, the META PROFILERTM is a handheld device born from a high-performance laboratory technology used in more than 20 clinical studies to measure skincare efficacy with time. 

This high-precision tool replicates precise clinical lab measurements thanks to its combination of 18 analytical LEDs and 3 capture modes:

• • Parallel polarized mode to capture wrinkles and texture
  • Cross polarized mode to capture pigmentation disorders & tone quality
  • 3D mode to capture smoothness and skin texture

Associated with a real-time hydration sensor and an algorithm built on more than 100.000 skin captures, the META PROFILERTM high-precision camera is able to measure more than 13 different clinical skin markers (such as wrinkles, dark spots, and redness).

HIGH-PRECISION IN-STORE CONSULTATION

The META PROFILERTM service is an in-store, 10-minute diagnostic consultation that analyzes the consumer’s skin in high precision for a tailor-made CREMA NERA routine and personalized Armani “Meta SculptTM” face treatment recommendation.

The consultation begins with a skin-capture phase: an Armani beauty Face Designer places the META PROFILERTM device on 4 specific facial zones to capture skin measurements in high precision: forehead, cheeks, crow’s feet, and pigmented areas.

 Then, the consumer is presented with his/her skin vital force index, categorized into 4 skin criteria: structure, tone, balance, and texture. objectivize skin’s potential to revive and protect against the aging process from a visible point of view.

Based on these results, the consumer will receive a tailor-made CREMA NERA product recommendation routine, associated with personalized gestures; The consumer may also book an in-store 45-minute “Meta SculptTM” facial protocol, a powerful massage service to stimulate & sculpt facial fascia.

This firm clearly understand their customer’s needs and deliver a high quality and high touch solution. This also shows the power of Omnichannel client experience. L’Oreal are trying to stop their customers expensive ‘trial & error’ approach to addressing their skin care needs. Likely more cost effective for customers and more efficient for L’Oreal.

Company revenues in 2018 were €27bn, the equivalent number in 2023 was €41bn. This reflects the connection this firm has with its customers and the experience they have with the products. The combination of an omnichannel model, desirable products and effective innovation has facilitated the firm’s growth.

Conclusion

Strategies that invest in companies that increase their revenues and profits by putting money back into their business each year to either grow their capacity or create new products and services can be a good investment. AI can enhance each part of the financial measures of a firm by (1) reaching more potential customers (2) have more understanding of what makes people buy their products and services, (3) be more efficient by automating tasks or organising production and distribution lines (4) new products & services through research & development spend.

AI will have a huge impact on our lives and our investments. This technology will not only belong to the ‘Manufacturers’ in technology sector but also to the ‘Practitioner’ firms who provide solutions to the world’s problems.

Financial advisors should consider investing their clients’ savings in investment strategies with exposure to companies leveraging the power of AI to deliver growth. Those will not be limited to technology companies. By incorporating such investments, advisors can offer exposure to innovative technologies while mitigating risks associated with sector-specific fluctuations, potentially enhancing the overall resilience and growth potential of their clients’ portfolios.

By Neil Sutherland, Dundas Global Investors, Edinburgh.

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Disclaimer : This document has been prepared by Apostle Funds Management Pty Limited (“Apostle”) (ABN 16 129 922 612) (AFSL No. 458375). The Apostle Dundas Global Equity Fund (ARSN 093 116 771) is issued by K2 Asset Management Ltd (“K2”) (ABN  95 085 445 094)(AFSL No. 244393), a wholly owned subsidiary of K2 Asset Management Holdings Limited (ABN 59 124 636 782). This material and the content of any offer document for the investment are principally governed by Australian rather than New Zealand law. This material may contain information provided directly by third parties which include Dundas Partners, LLP (AFSL No. 527238). This material is for information purposes only. It is not an offer or a recommendation to invest and it should not be relied upon by investors in making an investment decision. Offers to invest will only be made in the product disclosure statement (“PDS”) available from https://www.k2am.com.au/forms-apostle-dundas and this material is not intended to substitute the PDS which outlines the risks involved and other relevant information. Any investment carries potential risks and fees which are described in the PDS. An investor should, before deciding whether to invest, consider the appropriateness of the investment, having regard to both the PDS in its entirety and the investor’s objectives, financial situation and need. This information has not been prepared taking into account your objectives, financial situation or needs. Please note that past investment performance is not a reliable indicator of future investment performance. No representation is made as to future performance or volatility of the investment. In particular, there is no guarantee that the investment objectives and investment strategy set out in this presentation may be successful.  Any forward-looking statements, opinions and estimates provided in this material are based on assumptions and contingencies which are subject to change without notice and should not be relied upon as an indication of the future performance.  Persons should rely solely upon their own investigations in respect of the subject matter discussed in this material. No representations or warranties, expressed or implied, are made as to the accuracy or completeness of the information, opinions and conclusions contained in this material.  In preparing these materials, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available to Apostle. To the maximum extent permitted by law, all liability in reliance on this material is expressly disclaimed. This document is strictly confidential and is intended solely for the use of the person to whom it has been delivered. It may not be reproduced, distributed or published, in whole or in part, without the prior approval of Apostle. Third party distributors may be used to market the investment to New Zealand investors. Where this occurs, this material can only be provided to New Zealand persons that the New Zealand distributor is authorised to deal with under New Zealand law, and is not available to any person to whom it would be unlawful to make such offer or invitation.

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Karyn West

Independent investment research house, Lonsec, has awarded a ‘Recommended’ rating to the Apostle Dundas Global Equity Fund (the Fund).

The Fund is focused on sustainable dividends from long-term investment in global equities across developed and emerging markets.

Investment manager Dundas Global Investors (Dundas) aims to build a diversified portfolio of between 60-80 stocks with sustained business and dividend growth to achieve long-term capital growth. Strong qualitative and financial research and analysis underpins the Dundas investment criteria. The Fund has typically outperformed in weaker markets and underperformed in strongly rising markets.

The firm’s Senior Partner, Alan McFarlane, explains, “We pick stocks capable of sustained dividend growth and avoid the majority that aren’t. Our companies provide products and services bought by more customers year after year. Rising sales produce increased profit and cash flow which is applied first in reinvestment for future growth and second to pay each year’s dividends. Good companies run by excellent boards and management make repeated good capital allocation decisions, avoiding unnecessary financial risk to reduce the risk of dividend cuts. Consistent reinvestment by growing companies is the foundation for future dividend growth and our strategy’s success.

“In 2020 global dividends suffered a 13% reduction – just under $175 billion – with the cuts concentrated in industries most affected by lockdown and others that struggled because of changing demand patterns and / or poor capital allocation decisions. Avoiding those industries and companies was key to our recent results. COVID-19 exposed the difference between sustainable businesses and the rest.” Mr McFarlane said.

“Dividend growth investing is often confused with investing for high-yield but they are chalk and cheese. 2020 exposed the difference between on the one hand companies capable of sustained dividend growth because of the industries they operate in and the way they are managed and, on the other, over-distributing companies whose high yields signal their lack of opportunity to reinvest for future growth. Sustained dividend growth coupled with sound corporate financial governance are the keys to why dividend growth portfolios play defence well.” Mr McFarlane added.

The Fund’s Recommended rating can be attributed to the highly experienced professionals from both Dundas and Apostle Funds Management.

Karyn West, Managing Director, Apostle Funds Management (AFM) said, “During 2020, the best dividend policy for most companies was to hold cash to fund their business during the tough times experienced in a pandemic environment. Ordinarily Dundas likes to primarily see Boards allocating profits to help grow the business and then subsequently reward shareholders with a sustainable dividend year-on-year.

“Finding businesses that have good return on equity, good margins and pricing power are important as global economies find their feet within the challenges of the pandemic,” Ms West said.

Ms. West welcomed Lonsec’s Recommended rating as positive affirmation for the Fund, AFM and its global equity partners Dundas. “Our key focus at AFM is to provide investment strategies that meet a genuine client need. Advocating for clients’ interests and finding best-of-breed investments from around the world is at our core.”

Ms. West concluded: “We are pleased to be building strong momentum in providing targeted, hand-picked investment opportunities for our clients. Partnerships with quality asset managers like Dundas enable us to support client objectives via access to bespoke product solutions.”

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What are the differences between ETFs, LICs and Unlisted Managed Funds?

Exchange Traded Funds (ETFs), Listed Investment Companies (LICs) and Unlisted Managed Funds are all popular vehicle structures amongst investment managers to deliver portfolios to their clients. While there are similarities between each structure, there are also a number of key differences that clients must be aware of, as these differences ultimately determine the most suitable vehicle structure for their specific needs.

What are ETFs and how do they work?

An ETF is a registered managed investment – a type of ‘unit trust’ – that trades on a stock exchange in the same way that a share in a listed-company does. Through a single tradeable security, unit holders gain exposure to a portfolio of securities without having to individually trade and hold these securities themselves. This gives them access to a diversified portfolio of investments through one single trade.

Although they share the same trading process, ETFs are priced differently to listed shares on an exchange. The share price of an ETF is based on the Net Asset Value of the Fund’s underlying holdings, similar to an unlisted unit trust.  Their intraday price is referred to as the iNAV (intraday Net Asset Value), which aims to reflect the value of the portfolio’s underlying assets. As ETFs are priced based on their iNAV, they do not experience discounts or premia in the same way that market-priced securities do.

Like any share on an exchange, investors can buy or sell units in an ETF on the secondary market via their broker. They are open ended, meaning the number of units on issue can be increased or decreased in response to demand from investors. This helps ensure that the market price stays at or very close to the NAV. They trade intraday between buyers and sellers through a designated Market Maker. The Market Maker’s role is to provide liquidity to the market by quoting ongoing buy and sell prices throughout the trading day, which is referred to as the buy/sell or bid/ask spread. They place this spread around the iNAV and update it frequently throughout the day as the value of the Fund’s underlying assets change.

Passive ETFs

Due to their ability to track a portfolio’s net asset value, ETFs have become the first-choice vehicle for clients seeking passive investment strategies. Passive ETFs have existed since 1993 when State Street launched the SPDR S&P 500 ETF in the US. Clients now have access to a vast range of passive ETFs that track the indexes of markets, sectors, currencies, commodities and a plethora of themes and trends around the world.

For clients who are not believers in active management, passive ETFs can offer broad Beta strategies with total costs typically around 40 bps. See below a fee breakdown of some popular passive ETFs providing broad exposure to the Australian market

These low all-in fees are reflected in the cumulative returns of each ETF shown below. The slightly different returns of each ETF are explained by the differences in their mandates. Over time, however, these passive ETFs provide clients with relatively similar returns.

Active ETFs

Although passive ETFs account for the majority of the market, active ETFs have seen a surge in popularity in recent times. In Australia, active ETF issuance started to evolve in early 2015 when issuers and regulators agreed on a portfolio disclosure regime that balanced the needs of clients who want to know what they are investing in with the protection of the investment manager’s intellectual property (its portfolio holdings and active portfolio decisions).

Whilst active products charge higher fees than passive products, the costs of active ETFs are coming down as more participants enter the market. The Apostle Dundas Global Equity Fund ETF (ADGEF), for example, will be coming to market with an all-in management fee of 0.9% p.a and no performance fee. This is expected to launch to market in late February. For clients who are believers that active management can deliver outperformance relative to the market over time, these slightly higher management fees are more than offset by superior performance.  This is demonstrated by the Fund’s significant outperformance against the MSCI All Country World Index (ACWI), shown below.

What are LICs and how do they work?

An LIC is a closed-ended, exchange-traded vehicle that is unique to the Australian market. Unlike other investment vehicles, LIC unit holders do not hold a portfolio of assets. Rather, they hold units in an incorporated company, meaning the value of their investment is determined by market pricing rather than net asset value.

A key feature of LICs is the investment management agreement (IMA) they have with the underlying investment manager. These agreements are structured between 5 and 10 years, with the manager receiving locked-in fees for the duration of this agreement. Whilst this structure can be highly beneficial to investment managers, there are various features that are disadvantageous to clients, such as distributions. Unlike other investment vehicles that pass on all of their underlying assets’ dividends to clients, LICs have no distribution obligations. Rather, the LIC’s board of directors determines whether or not the company will pay a dividend and, if so, how large that dividend will be. For clients seeking income alongside capital appreciation, LICs are unlikely to be suitable investments.

Another disadvantage of LICs is that both investment managers and clients incur high costs relative to other structures.  Firstly, managers incur high operating costs due to the incorporated company structure, which is consequently reflected in the fees charged to clients. Additionally, clients incur price costs due to the tendency of LICs to trade at a discount to their underlying net asset value.

A significant difference between LICs and other investment vehicles which clients should be aware of is their performance reporting. Whilst LICs report on the performance of their underlying portfolios like any other investment vehicle, this is not actually reflective of a client’s investment performance. Rather, LIC capital appreciation is determined by the securities price return, which is not disclosed in reporting. Although this can be easily calculated using historical prices, it is essential that clients understand the distinction between the performance reported by LICs and the actual performance of their investment.  Additionally, LICs are only required to report gross returns when disclosing the performance of their underlying portfolios, whereas other investment vehicles are required to report both gross and net returns. This is also important for clients to understand as net returns reflect their realized investment performance.

What is an Unlisted Managed Fund and how does it work?

An Unlisted Managed Fund is a unit trust that can only be accessed through the Fund’s Investment Manager. Whilst their underlying portfolios are similar to those of exchange traded products, the key differences lie in the ease with which a client can make an investment in the Fund. They require a greater amount of administrative work than investments in a listed product due to the lack of a third-party administrative framework that public exchanges provide. The consequence of these greater administrative requirements is that clients cannot invest and withdraw their funds as quickly as they can on an exchange.

The terms of investment offered by unlisted fund managers can vary greatly between different funds. For example, whilst some funds offer daily pricing and daily liquidity, other funds may offer highly illiquid terms and can have lock-up clauses spanning multiple years. Although nuances such as this make unlisted funds less suitable for clients with minimal investment knowledge, they also provide a greater opportunity set than listed investment vehicles as they have access to a wider range of asset classes and investment styles. For example, whilst ETFs are required to limit their portfolio holdings to liquid assets, unlisted funds are unrestricted in the assets they can hold, which gives them a greater ability to provide niche strategies for specific client needs.

A less beneficial nuance of unlisted funds that clients should be aware of is that they have less stringent transparency requirements. Whilst all unlisted funds are registered under the Investment Company Act of 1940 and, consequently, must provide regular SEC filings, their disclosures are not made as publicly available as listed funds. For example, while listed funds have their portfolio holdings disclosures published quarterly on the ASX or Chi-X, unlisted funds are not required to make their disclosures publicly available, so long as they have been disclosed to the relevant regulatory bodies. Whilst this can be beneficial to managers seeking to protect their intellectual property, it has consequences for clients by making it more difficult to assess investment opportunities.

Comparison

Structure

• ETFs are open ended, meaning the manager can issue or redeem units. Clients buy units in a Fund, meaning they gain access to the Fund’s underlying assets.
• LICs are closed-ended, meaning there is a fixed number of units on issue. Clients buy units in a company as opposed to a Fund.
• Unlisted funds can be both closed-ended and open-ended. Like ETFs, clients buy units in a Fund, meaning they gain access to the Fund’s underlying assets.

Unit pricing

• ETFs trade at iNAV, so client returns are in line with those of the underlying portfolio.
• LICs are priced by the market and can therefore be priced at a discount or premium to the underlying assets of the investment company.
• Unlisted funds trade at Net Asset Value. This is different to iNAV as it is priced periodically (i.e daily) as opposed to intra-daily.

Income

• ETF pass on all distributions from underlying assets to their unit holders.
• LIC managers have no obligation to pass on the dividends of their underlying assets to unitholders. The board of directors will determine the dividend payment each financial year, if they choose to pay a dividend at all.
• Unlisted funds pass on all distributions from underlying assets to their unit holders.

Fees

• ETFs tend to charge their clients relatively low management fees, but clients will incur brokerage fees every time they trade an ETF unit.
• LICs generally incur higher operating costs than other vehicles and, thus, charge their clients higher fees. A larger portion of LICs have active managers than ETFs, which in turn leads to higher management fees.
• Unlisted Funds vary in their management fees depending on multiple factors, such as capacity constraints and asset class. However, most unlisted funds are actively managed, leading to higher management fees than those in the predominantly-passive ETF market.

Liquidity

• ETFs have intraday liquidity, meaning clients can buy or sell their units quickly and easily via their brokers on the ASX or Chi-X.
• LICs also have intraday liquidity available, but their lack of a designated market maker means that liquidity is determined by market supply and demand.
• Unlisted funds have varying liquidity. The most liquid of these funds can provide clients with the ability to invest or withdraw capital in a matter of days.

Tax

• ETFs do not pay income tax as they pass on all income to unit holders. Clients are taxed at their marginal tax rate.
• LICs pay 30% income tax
• Unlisted funds do not pay income tax as they pass on all income to unit holders. Clients are taxed at their marginal tax rate.

Administrative ease

• ETFs are traded easily on an exchange through a broker.
• LICs are also traded easily on an exchange through a broker.
• Unlisted funds require greater administrative work due to the lack of a third-party administrative framework (such as an exchange). This is typically a T+2 confirmation process.

Consolidated reporting

• ETFs are required to disclose their gross and net returns monthly, as well as their portfolio holdings quarterly. These disclosures are publicly available on the ASX or Chi-X.
• LICs are required to report the gross return of their underlying portfolio. They are not required to report net performance, nor their unit price return.
• Unlisted funds must disclose their gross and net returns monthly, as well as their portfolio holdings quarterly, but are not required to make them publicly available.

Business approach to the Listed Markets

Apostle Funds Management currently manages A$1bn using Dundas Global Investors as the underlying global equity manager of an unlisted Trust.

Due to significant market demand and feedback, many of our clients have shown interest in a listed vehicle. We had the option of choosing between an ETF and a LIC. Weighing up the pros and cons as outlined above, we determined that an ETF option would suit our client’s needs best.

Many IFAs and brokers prefer the ETF structure to manage their clients’ equity holdings through CHESS. They see great value in the ETF model due to features such as intraday pricing and liquidity, which are not provided by unlisted funds. We view the addition of an ETF as providing multiple access points to one underlying portfolio to provide choice to the market.

Why ETF over LIC?

Clients will find an ETF to be more suitable than an LIC for two reasons:

1. Pricing is determined by the underlying value (NAV) of the portfolio and do not trade at a premium or discount. LICs are likely to trade at a discount to NAV, so clients may not receive the full return provided by Dundas’ outperformance.
2. Clients will also favour the ETF structure as unitholders will receive all distributions from the Fund’s underlying holdings. LICs are not required to pay these distributions.

Financial planners would need to explain why an LIC’s portfolio underperforms to the market when it is trading at a discount, which can be complicated and frustrating for clients.

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Sources:
Apostle Funds Management. (2020). ETFs vs LICs vs Unit Trusts.
ASIC. (2020). Managed Investment Schemes.
ASX. (2020). ASX Investment Products – ETFs.
Dundas Global Investors. (2020). Apostle Dundas Global Equity Fund – December 2020 Factsheet.
K2 Asset Management. (2018). Listed Funds – Recap.
Morningstar Australia. (2020).
Yahoo Finance. (2020).

Apostle Funds Management Pty Limited ABN 16 129 922 612 AFSL No. 45 83 75 (“Apostle”) The attached or accompanying document or information has been issued by Apostle and includes information from third parties. The third parties may include Investment Managers who conduct any portfolio management activities in and from overseas countries and who may be exempt from the requirement to hold an AFSL under the Corporations Act 2001 (Cth) in respect of financial services. These third parties are regulated by the relevant authorities in their country under laws which differ from Australian laws. This material is for information purposes only. It is not an offer or a recommendation to invest and should not be relied upon by investors in making an investment decision. Offers to invest will only be made in the relevant offer document and this material is not intended to substitute for suitable disclosure documents which will outline the risks involved and other relevant information. Any investment carries potential risks and fees which are described in the relevant offer document. An investor should, before deciding whether to invest, consider the appropriateness of the investment, having regard to both the relevant offer document in its entirety and the investor’s objectives, financial situation and need. This information may not have been prepared taking into account your objectives, financial situation or needs. Please note that past investment performance is not a reliable indicator of future investment performance. No representation is made as to future performance or volatility of the investment. In particular, there is no guarantee that the investment objectives and investment strategy set out in this presentation may be successful. Any forward-looking statements, opinions and estimates provided in this material are based on assumptions and contingencies which are subject to change without notice and should not be relied upon as an indication of the future performance. Persons should rely solely upon their own investigations in respect of the subject matter discussed in this material. No representations or warranties, express or implied, are made as to the accuracy or completeness of the information, opinions and conclusions contained in this material. In preparing these materials, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available to Apostle. To the extent permitted by law, all liability in reliance on this material is expressly disclaimed.  This document is strictly confidential and is intended solely for the use of the person to whom it has been delivered. It may not be reproduced, distributed or published, in whole or in part, without the prior approval of Apostle. This material is provided in relation to an investment that is available exclusively to wholesale clients, as defined by the Corporations Act 2001 (Cth). This material is provided in relation to an investment that is open to Australian residents only and is not available in any jurisdiction in which, or to any person to whom, it would be unlawful to make such offer or invitation.

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The outlook for Australian companies looks susceptible to the market turbulence created by the COVID pandemic.

This paper will discuss the outlook for the Australian equity market with regards to dividends and the subsequent impact this will have on total returns. Despite having a history of consistent dividends and high payout ratios, and the added benefit of the imputation tax system, the outlook for Australian companies looks susceptible to the market turbulence created by the COVID pandemic, with many industries facing strong headwinds. This has exposed issues in the fundamentals of the Australian market, such as a lack of diversification by industry and market cap, which may present a case for increased global diversification in your clients’ portfolios.

2020 has seen a cutting or deferring of dividends in an effort to prioritize the survival of the business over distributing cash payments to shareholders. As global GDP contracted, companies with high levels of operational gearing feared a material impact on profitability and even solvency. The ability to cancel or delay dividends is an important source of funding to preserve balance sheets. Almost a quarter of Australian companies have cut or deferred their dividends since the Coronavirus fallout. These suspensions have been widespread across industries, including the major banks, who have often been relied upon for reliable dividends.

Among the hardest hit are self-funded retirees, many of whom rely heavily on dividends and franking credits from income-paying stocks to fund their retirement. Asset managers say this reliance has become acute in the past few years amid record low interest rates, with retirees loading up on financial sector stocks with the promise of high yields.

The Australian market has a reputation for high levels of dividends so the growing list of companies suspending dividends is a blow to income investors who rely on the payouts as a tax-effective cash flow source. In fact, companies listed on the ASX have seen the largest dividend downgrades across the globe in 2020, with Australian dividends-per-share (DPS) undercutting analyst expectations by over 20%. In the calendar year to 31^st October, 2020.

Australia’s concentrated risk

The Australian market is heavily weighted towards a smaller number of industries, being heavily concentrated in financials and materials (see below). In the MSCI Australia index, the Financials sector is the largest and is almost 18% larger than in the MSCI ACWI. The Materials sector also has a relatively large sector position 15% higher than it’s global counterpart. On the other side, the largest sector in the global markets, IT, is higher than in MSCI Australia by almost 20%. Communication services and Consumer Discretionary sectors both have relative over-weights for ACWI in excess of 5%.

In addition, the top 50 Australian stocks have a high concentration in a small number of large-cap stocks  and then a very long tail of mid-to-small caps. It is generally not well diversified compared to the MSCI ACWI. Of the 2000+ stocks listed on the Australian Securities Exchange, the top 200 stocks account for 82% of the country’s total market capitalization. Of these 2000+ stocks, around one third are junior metal and mining stocks by number, yet the entire listed materials sector accounts for only 15% of the index’s market cap. In contrast, financials only account for 5% of listed companies by number but 36% of the index’s market cap.

In comparison, the MSCI ACWI offers greater diversification by volume of companies, with approximately 630,000 companies traded publicly throughout the world. The US still has one of the largest exchanges in the world, but many of the fastest growing exchanges now reside in Asia.

The MSCI ACWI is designed to represent the full opportunity set of large and mid-cap stocks across 23 developed and 26 emerging markets.

The MSCI ACWI has clear diversification benefits over the MSCI Australia, with significantly less concentration in its largest holdings, as well as a more even spread across sectors.

How has Australia performed?

Over the medium term, the global markets (MSCI ACWI) have outperformed the Australian market by a comfortable margin (see below).

The table below shows the risk-return comparison between various markets, which also confirms that over the long-term ( 10 years), global markets provide a higher return and lower risk than the Australian market. The reasons for this are to do with structural differences, opportunity set and diversification.

Evidently, the addition of global stocks into your clients’ portfolios can bring the benefit of increased diversification, access to growth sectors not easily or readily available in Australia and offers higher returns with lower risk.

What is the future dividend outlook in Australia compared to the rest of the world?

In many ways, the FY20 reporting season was one of the most closely watched in recent memory as investors attempted to understand the true impact of the COVID-19 pandemic on company fundamentals. Going into the end of the financial year, expectations for earnings had been slashed significantly across the globe due to the level of uncertainty that remained in the outlook for the economy. This had particular implications for Australian equity investors, whose portfolios are typically overweight in high dividend-paying stocks and rely heavily on companies distributing their earnings. With the unexpected market turbulence of 2020 exposing this fundamental flaw in the Australian equity market, the benefits of holding a globally-diversified portfolio will be increasingly apparent to your clients.

Australia has historically been a high dividend paying market. This is because of Australia’s almost unique franking credit tax breaks, which lead investors to favour higher dividend paying companies. These companies are rewarded with higher share prices in favour of companies that are reinvesting into their business. As a result, Australia is currently delivering a 3.5% dividend yield against the MSCI ACWI’s divided yield of around 2%, placing it second in the world behind only the UK.

Dividend yield is primarily driven by dividend payout ratio (shown below), which results in these two graphs closely mirroring each other in many markets across the globe.

The payout ratio is a financial metric showing the proportion of earnings a company pays shareholders in the form of dividends, expressed as a percentage of the company’s total earnings. The dividend payout ratio helps investors determine which companies align best with their investment goal. A high ratio may be attractive to income investors who prefer the assurance of a steady stream of income but forgo high potential for growth in the share price. A low ratio means that the company is reinvesting money back into expanding its business. By virtue of investing in business growth, the company will be more likely to generate higher levels of capital gains for investors in the future. Younger, more rapidly growing companies are likely to reinvest most of their earnings for future growth whereas more mature, established companies are likely to have a high pay out ratio.
The payout ratio may vary greatly from one industry to another. Many high-tech industries tend to distribute less in dividends, whereas a utility is likely to distribute a large portion of their earnings. The below chart confirms the Australian market as being a higher dividend, higher payout ratio market with 75% of all stocks paying out 50% or more of their revenues. 18% of companies have a higher retention rate and 7% having the highest reinvestment rate of the market.

The below chart shows the industries which supply the highest dividend yields. The highest paying sectors are unlikely to be companies growing at the faster rates into the future. Examples are utilities, real estate and financials. Often companies that are paying out high dividend yields are companies that have lower or stagnant growth and are considered to be cash cows. These could also be dividend traps. A dividend trap is a stock that lures investors in with a high yield only to result in a potential dividend cut or financial distress. Buying stocks with high yields can lead investors into troubled sectors. When a stock’s price declines, its yield will rise. In order for companies to have vibrant growth into the future, a good portion of their revenues need to be retained for future growth. There are some sectors in Australia that reinvest for future growth currently reinvesting with a payout ratio of 50-60% such as the healthcare and IT sectors. But for a broader diversified portfolio of these types of stocks there are richer pickings off shore.

The consequence of Australia’s high payout ratios, however, is that they entice companies to forego sufficient cash reserves in favour of distributions, forcing them to drastically cut dividends during down markets with no financial buffer in place. It should come as no surprise that this fundamental issue has been surfaced during the COVID pandemic.

Since May 2000, the ASX 200 has returned an average of 7 per cent annually. The proportion of total return that comes from dividends is around 60 per cent, leaving your Australian clients heavily exposed to dividend cuts.

Investing in companies with sustainable dividends

Dividend sustainability manager Dundas Global Investors maintains that although the pool of companies maintaining and growing their dividends is shrinking, there is still a significant number of suitable stocks for this style. Dundas pay careful attention to the sustainability of future dividends through careful management of the reinvestment of revenues first before rewarding shareholders. They look to industries that have good tailwinds, which during the COVID crisis, industries such as healthcare, IT and logistics have benefitted from this environment.

Although dividends may resume post COVID-19, there is no doubt the virus has hit all economies with high unemployment, as well as issues for the banking sector, shopping centres and retail, hospitality, tourism and many more. The additional benefit of the size and scope of global markets will be a better hunting ground for sustainable dividends than investing in the Australian market alone.

With record low interest rates spurring the hunt for yield, there may be more need for other sections of your clients’ portfolios to bridge the gap on income requirements. Finding revenues from stocks that are somewhat resistant to economic downturns with good future growth potential will be an important factor for client portfolios.  These may be used in conjunction with higher yielding stocks to bridge the gap of current income combined with future income. Avoiding industries with headwinds as a result of the new economic environment will require careful portfolio construction.

High growth stocks, particularly in the tech sector such as Facebook, Apple, Amazon, Netflix and Google comprise 20-25% of market capitalization of the S&P500 as at September. They account for nearly all of the gains in that index for the year to date. Technology stocks have received significant benefits from the lockdown as consumers made online purchases and watched streaming services. However, this is not the entire story and is not a representation of the broader market. In the past year to 30 September, the MSCI returned 4.3% in USD. In Australia, there were only 14 companies which outperformed the benchmark. On the other hand, the MSCI ACWI had 1,173 stocks which outperformed. This shows the greater scope from a broader universe to choose from. Interestingly, the USA contributed 265 stocks to the 1,173 outperformers. Although US stocks receive more than their fair share of news time, the rest of the world provides good long-term performing companies with sustainable dividend characteristics. For example, Europe’s exposure to financials and cyclically sensitive sectors in industrials and materials give it the potential to perform well when economic activity picks up.

The outlook for Australia shows some economic headwinds as a result of the lockdowns. Stretched household budgets and limited tourism will have an extended impact. The Reserve Bank of Australia has reduced interest rates to an all time low of 10 basis points.

Improving your clients’ risk-adjusted returns

Global equities are a key part of portfolio diversification. Asset allocation will be the core driver of total investment return and with the outlook for the economy and business profitability more uncertain, the Australian market alone may not meet diversification and income requirements.

Given the size of the Australian market relative to the MSCI, there are some key sectors and exposures that your clients will be missing out on. A home bias to Australia has been shown to be suboptimal for client portfolios over most timeframes. Given the equity markets broadly reflect the earnings of the underlying economy, it is important to look at the structure of the Australian market and the headwinds for the key sectors. The banking sector represents 27% of the market.  It has historically provided rich dividend hunting ground but the outlook is much poorer. With our shallower market by number of companies and sectors, the dividend shortfall may need to come from a global portfolio.

Exposure to global markets can be done through ETFs and there are also ETFs that focus on dividends. However, these are backward looking indices that do not focus on the future outlook for dividends by companies nor headwinds or tailwinds by industry. For an active portfolio which will look forward to future dividend capabilities by company, you can seek out managers such as Dundas Global Investors.

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Sources:
Bergmann, M. (2016). The Rise in Dividend Payments. Reserve Bank of Australia.
Bloomberg Finance L.P. (2020). Retrieved from Bloomberg database.
Dundas Global Investors. (2020). Apostle Dundas Global Equity Fund – In Search of Growth.
Lundberg, A. (2020). Australian Dividends Forecast to be Cut Most in the World. Montgomery Investment Management. Retrieved from: https://montinvest.com/investor-insights/insights/australian-dividends-forecast-to-be-cut-the-most-in-the-world/
MSCI, Inc. (2020). MSCI Index Solutions. Retrieved from: https://www.msci.com/index-solutions

Apostle Funds Management Pty Limited ABN 16 129 922 612 AFSL No. 45 83 75 (“Apostle”). The attached or accompanying document or information has been issued by Apostle and includes information from third parties. The third parties may include Investment Managers who conduct any portfolio management activities in and from overseas countries and who may be exempt from the requirement to hold an AFSL under the Corporations Act 2001 (Cth) in respect of financial services. These third parties are regulated by the relevant authorities in their country under laws which differ from Australian laws. This material is for information purposes only. It is not an offer or a recommendation to invest and should not be relied upon by investors in making an investment decision. Offers to invest will only be made in the relevant offer document and this material is not intended to substitute for suitable disclosure documents which will outline the risks involved and other relevant information. Any investment carries potential risks and fees which are described in the relevant offer document. An investor should, before deciding whether to invest, consider the appropriateness of the investment, having regard to both the relevant offer document in its entirety and the investor’s objectives, financial situation and need. This information may not have been prepared taking into account your objectives, financial situation or needs. Please note that past investment performance is not a reliable indicator of future investment performance. No representation is made as to future performance or volatility of the investment. In particular, there is no guarantee that the investment objectives and investment strategy set out in this presentation may be successful.  Any forward-looking statements, opinions and estimates provided in this material are based on assumptions and contingencies which are subject to change without notice and should not be relied upon as an indication of the future performance.  Persons should rely solely upon their own investigations in respect of the subject matter discussed in this material. No representations or warranties, express or implied, are made as to the accuracy or completeness of the information, opinions and conclusions contained in this material.  In preparing these materials, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available to Apostle. To the extent permitted by law, all liability in reliance on this material is expressly disclaimed. This document is strictly confidential and is intended solely for the use of the person to whom it has been delivered. It may not be reproduced, distributed or published, in whole or in part, without the prior approval of Apostle. This material is provided in relation to an investment that is available exclusively to wholesale clients, as defined by the Corporations Act 2001 (Cth). This material is provided in relation to an investment that is open to Australian residents only and is not available in any jurisdiction in which, or to any person to whom, it would be unlawful to make such offer or invitation.

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To access a sustainable dividend style portfolio find an active manager that specialize in this style.

Companies that exhibit sustainably growing dividends do not seek to generate a high income stream, nor do they try to be the fastest growing businesses. Sustainable dividend growth is a total return focused equity strategy with defensive characteristics. Dividend growers tend to preserve capital relatively well in downturns and this low volatility approach can lead to considerable outperformance over a market cycle.  They seek superior downside protection and an attractive risk/reward profile.

Dividends are paid to shareholders from company profits. So, for long-term investors, profit after tax is the material metric in any set of accounts because that figure is essentially the amount of new equity capital that has been generated in the course of the business plying its trade.

One of the most important decisions for a company’s board and management team is how best to deploy that new equity capital. Broadly speaking there are two options: distribute it to shareholders; or retain it in the business and put it to work in fueling expansion, making acquisitions, developing products and services, or repaying debt.

Companies with growing demand for their products need to retain most of their net income to fund expansion, with the majority of high-growth businesses reinvesting all their profits in the early years, and sometimes even asking investors for extra capital to supplement it. More established, successful companies will achieve the happy outcome of generating sufficient amounts of cash to fund their growth with enough surplus to pay dividends to shareholders.

Those dividends reward investors for the risk they took in buying shares in the company and the payments have come to be accepted by both parties as a virtual covenant. Dividends are the ultimate expression of faith in the future prosperity of a company. As such, once they have been embarked upon, boards and management need to be confident those payments can be sustained.

Company Executives need to manage their businesses wisely to be confident that their future cash flows can maintain and grow dividends. Once a dividend stream is underway, the market will punish any company that cuts their dividend. It is a self-imposed discipline on executives and boards to place cash back to shareholders. Their other options would be to fund acquisitions which may have an uncertainty of outcome, buyback shares, usually to improve executives’ payments and bonuses or sit on cash. Dividend growers have a highly loyal shareholding base that is less susceptible to market price volatility.

Microsoft is a case in point. The company has proven resolutely committed to growing its dividends, while simultaneously maintaining a high growth profile with new investments in the cloud business. Its solid fundamentals and strong governance make it extremely unlikely that the company will forego on its commitments. Its positioning at the edge of cloud computing, meanwhile, makes its stock an exciting growth prospect.

Interestingly, dividend growers do not typically provide the highest yield in the market. Many of the highest yielding companies are in mature industries and are companies with lower prospects of capital growth, offering a higher payout ratio to income hungry shareholders. This is at the detriment to future growth of our client’s portfolio. A dividend trap is a stock that lures investors with a high yield only to result in a potential dividend cut or financial distress. Buying stocks with high yields can lead investors into troubled sectors. When a stock’s price declines, its yield will rise.

The company’s payout ratio is a proportion of profits paid out to shareholders in the form of dividends. A high payout ratio may not be sustainable and may lead to the dividend being cut. The payout ratio should be a disciplined ratio of reinvesting into the company for future growth and then rewarding shareholders after a margin of safety or business risk has been established.

During down markets dividend growers typically outperform and this was evidenced in the 2007-2009 financial crises. The dividend growers preserved capital better than the general market. It is during a severe downturn that strong balance sheets will weather the storm better than most.

Over the long-term, dividend growing companies typically hold up well in down markets and are capable of excess return over the full cycle.

A lower volatility portfolio with shorter draw down will have a better risk-adjusted return than a highly volatile portfolio. Over time, minimizing drawdowns can result in significant gains to investors. Combined with the compounding effect of reinvesting dividends this can provide a stabilizing core to an overall equity portfolio. Ned Davis Research Group provided a paper discussing why minus 1% plus 1% does not equal 0%. A 20% loss in our portfolio would require a 25% gain in order to recover. For example, if a $100 portfolio loses $20 the capital base has shrunk to $80. This requires that investment gains must be larger to offset the now smaller capital base. This is shown in the following equation:

Recovery gain (%) = drawdown loss % divided by (100% – drawdown loss). The drawdown loss is more costly for larger drawdowns than for smaller drawdowns. The larger the drawdown the longer the recovery time. This reinforces the importance of drawdown reduction strategies in active portfolio management to minimise the pain and time experienced from drawdowns. If an active strategy can reasonably reduce drawdowns, there are good gains to be made.

A study done by the Norwegian Ministry of Finance into global market portfolios to examine the key drivers effecting returns found the following; “The return contribution from dividend growth increased and valuation adjustments decreased with increasing holding periods during the last two decades“. Their examination covered the period of December 94 to December 2015 and found that dividend yield and dividend growth explained most of the return and risk in the long run. Over the past 20 years, global equity prices have grown approximately in line with dividends.

The return decomposition of ACWI equities is presented in Chart 2. Non-overlapping annual data for the 1-year horizon and overlapping annual data for longer horizons is used. This analysis covers the historical period Dec 1994 to Sep 2015 and shows that the average contribution of the valuation adjustment term to total returns became smaller as the investment horizon became increasingly longer. Valuation changes accounted for approximately 50% of total returns over 1-year periods while their contribution fell to 20% over 10-years and to less than 10% over 20-years, reflecting the declining importance of valuation changes over longer horizons. On the contrary, the average contribution from dividend growth increased with increasing time horizon. Dividend growth was the highest contributor to equity returns, accounting for at least 60% of total equity returns over 10-year and 20-year periods. Dividend yield is the second largest return contributor, explaining nearly 30% of the total ACWI returns over 20 years.

The above chart shows the significant contribution made by dividend growth to total return. The dividends are relatively stable component compared to valuations of stocks. Dividend growth per share accounts for 64.5% of total equity return in the long run (20 years).

During COVID, the dividend landscape has shifted. Previously, many listed companies were undertaking buyback programs, which we have observed a cessation of across the globe. We have observed government intervention by regulators to stop both buybacks and dividends for banks and those benefiting from emergency policies.  We have already seen some dividend declines taking place. This may not necessarily be a bad thing during a period of uncertainty but is certainly worth keeping an eye on. Many are drawing down lines of credit to strengthen liquidity so there may be an overall deterioration of quality through this period. It will not be surprising to learn that many businesses are deeply troubled and the companies that did not have strong balance sheets before COVID will be struggling in this environment. Any company that had a strong balance sheet pre-COVID and has been able to maintain or grow their dividends throughout this period are prime candidates for investment. Unsurprisingly, these particular companies will be experiencing more stable or growing share prices.

Global dividends have fallen around 12% from 2019 run rate. This will likely be closer to a 20% decline once all declarations are known. Substantial debt issuing by companies across the globe may lead recovering cashflows.

Dividends are becoming a scarcer resource during the current COVID situation and looking into the future recessionary years but they will be an excellent barometer to assess a company’s health.

The S&P500 dividend futures contract tells an interesting story. $56 of dividend were paid on the index in 2019. In March, the futures were predicting an increase to $61.50 for 2020. By the market-low in April, that had become $40 and now sits back up at $56. For 2021 those figures were $64 in March, $35 in April and $51 now. In summary, the market is pricing in further cuts through this year and into next with 2022 being flat. The I.T. sector is certainly playing its part in keeping these dividends going accounting for around 15% of the total.

This suggests that through to the end of June, dividends have fallen around 12% on the prior year. With US dividends still having more falls to come (according to the futures anyway) and risks to the UK and elsewhere. With this is mind we might expect the 12 month run rate to get down to around $1150bn which would mean a 20% fall from the peak. That would take us back to 2016 levels but ahead of 2012.

Cross referencing to industry groups, a $150bn fall in dividends would be equivalent to around a 30% reduction in Financials and Energy dividends with all others balancing out to net zero. Looking ahead, US banks paid out dividends in Q1 which were substantially higher than profits for that quarter which was only just impacted by COVID-19, so we can expect to see more cuts there.

Many Energy companies have yet to decide on future dividend policy and with that sector accounting for 11% of global dividends there is more scope to the downside.

In summary:

• Global dividends have fallen around 12% from 2019 run rates.
• Likely this will be closer to a 20% decline when all declarations are revisited in Q1 of 2021.
• While there is potential for a European dividend rebound from politically depressed levels in 2021 (see below), recovery in US pay-outs may take longer.
• Substantial debt issuance by companies across the globe may lead recovering cash flows to be prioritised for debt repayment before dividends are reinstated or increased. It will take time to rebuild dividend cover, therefore, for dividend growth to pick up a considerable earnings recovery is needed.

In summary, a portfolio that focusses on the most stable and predictable component of return, dividends, is likely to produce a more defensive portfolio with better downside capture. Moreover, a process that focusses on the sustainability of dividends into the future has a higher probability of success than a passive, backward-looking index strategy.

Dividends are not only a reward for investors, but a statement of confidence by company management and directors; a declaration of strength and unwavering belief in the business’s fundamentals. Dividends send a clear message about the company’s current and future performance and its capacity for protecting shareholder value.

To access a sustainable dividend style portfolio, you will find there are some active managers that specialize in this style and they offer both managed investment trusts and ETFs will soon be available. Passive ETF options are also available, however they are backward-looking at historical dividends paid, rather than forward-looking to anticipate the winners and losers in the market.

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Sources:
Engel, K. & Wu, K. (2017). ‘Breaking Down Drawdowns and Recoveries’. NDR Solutions quarterly. Ned Davis Research Group.
Gupta et. Al. (2016). ‘Global Markets & Return Drivers’. Analysis for the ministry of Finance, Norway. MSCI Inc.
Lefkovitz, D. (2017). ‘Growing a Portfolio with dividend Growth Stocks’. Industry Insights from Morningstar Indexes. Morningstar Inc.

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