Kera Van Valen

In times of economic and political turbulence, investors seeking stability and long-term value should focus on companies still issuing dividends, according to Kera Van Valen, portfolio manager of GSFM fund manager partner, Epoch Investment Partners.

“Companies with consistent, well-managed dividend policies signal financial health, disciplined capital allocation, and a commitment to returning value to shareholders, even during uncertain periods,” Van Valen said.

“History shows that companies with stable and growing dividends tend to outperform companies that either don’t pay a dividend or have an inconsistent dividend policy resulting in cuts or reductions to dividends,” she added.

A diversified portfolio of high-quality companies that can generate sustainable free cash flow and consistently return cash to shareholders in the form of dividends, share buybacks, and debt reduction can deliver outperformance over the long-term for investors.

Diversifying dividend investment styles and adding the other components of shareholder yield in this way can lead to a better risk-return profile.

The chart below shows how this works in action, with a strategy that targets an annual average yield split of between 4 to 4.5 per cent in dividends, 1 to 1.5 per cent in share buy backs, and at least 3 per cent from cash flow growth.

Source: Morningstar Direct

While a mix of yield sources may not always provide the highest returns in the short term, research shows that it will provide more downside protection in the long term, leading to better results overall.

“This strategy puts investors in a much stronger position to gain long-term risk-adjusted returns, allowing them to weather volatility and have a smoother ride through the market cycle,” Van Valen said.

Companies that grow and pay

Two examples of global companies that pay their investors a strong and sustainable cash flow are Coca-Cola Europacific Partners (CCEP) and Deutsche Telekom (DTE).

“CCEP sustains its cash flow by maintaining efficient product distribution and having a differentiated pricing architecture, giving consumers the ability to buy its products at different price points.

“DTE, on the other hand, is a good example of how debt reduction can be used to increase equity holders’ claims on company cash flows,” said Van Valen.

DTE owns a majority interest in US mobile operator, T-Mobile. Following T-Mobile’s 2020 acquisition of Sprint, the company focused on bringing debt levels down. This focus resulted in material cost synergies, boosting free cash flow levels and enabling deleveraging of DTE’s balance sheet.

“Ultimately Deutsche Telekom was able to increase its dividend rate and initiate share repurchases, enabling the company to regain majority ownership of T-Mobile.

“T-Mobile was then able to initiate a standalone dividend, returning significant cash back to the parent company and further benefitting DTE shareholders.”

Van Valen said the outlook for income from global investments remains robust for 2025 with more companies paying dividends.

“Regardless of the somewhat uncertain global economic outlook, due to the obvious geopolitical factors, we believe the dividend outlook is strong, and the current rate environment and strength in cash flows give corporates no reason to abandon sound capital allocation practices,” Van Valen said.

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Kera Van Valen

There is currently no shortage of uncertainty in global markets, and it looks like things will remain that way for the foreseeable future.

The prolonged war in Ukraine coupled with escalating tensions between the U.S. and China continue to drive de-globalisation and stagnating economic growth. Recession risk remains elevated, as despite recent turmoil in the banking sector, central banks around the world are continuing the process of economic policy normalization. Attractive opportunities remain for equity investors, but to succeed in this environment will require a more hands-on approach to stock selection, with a heightened focus on business fundamentals.

With monetary policy more restrictive than it’s been in years, and likely not returning to the highly accommodative levels seen over the past decade any time soon, companies with a large share of their cash flows out in the future and a pressing need for capital injections to sustain growth will see valuations most significantly pressured when compared to more fundamentally sound peers. All signs point to the best opportunities being concentrated within highly cash generative, dividend-paying companies with healthy balance sheets and strong market positions. A portfolio constructed with these traits in mind will be well suited for the coming era of more fundamentally driven equity markets.

Portfolio pick – Novartis

The Epoch Global Equity Shareholder Yield portfolio invests in companies that grow free cash flow and allocate it intelligently. To illustrate what we are talking about, examples of companies that we hold in our portfolios are always a good place to start. One such stock worth highlighting is Swiss pharmaceutical company, Novartis. It’s a large company, with a market capitalisation of about $US200 billion, and it generated about $US50 billion in revenues last year.

The management team has been narrowing the focus of the business and has divested segments that are unrelated to their core interests of innovative medicines. This narrower focus has resulted in a much more dependable driver of growth in cash flow.

Novartis has exposure to different therapeutic areas across a number of geographies, which lends to more stability for the business. They have blockbuster drugs in oncology, in immunology, in cardiology, and in neuroscience. The company pays an attractive dividend which has been growing consistently and reliably for more than 20 years, and also regularly repurchases stock.

Portfolio pick – Coca Cola Euro Pacific Partners

Another great example of a holding in this strategy is Coca Cola Euro Pacific Partners (CCEP). It is the world’s largest independent bottler for the Coke franchise, with operations in Europe, Asia, and Australia. On a continuing basis, the company partners with Coke to optimise its product and price mix in each market, aspiring to have the ideal brand in the appropriate packages at the right prices in all target channels.

Nearer term, restructuring of the product offering and cost structure at recently acquired Coca-Cola Amatil will serve to accelerate free cash flow growth. Bigger picture, with strong brands and a diverse product portfolio, CCEP is well positioned to continue to drive growth in free cash flow through profitable revenue growth, volume, product innovation and marketplace execution. The company generates strong free cash flow and consistently returns cash to shareholders through an attractive dividend which is also supplemented by share buybacks and debt reduction. 

Wrap-up

When the market landscape is defined by uncertainty and volatility, as it remains today, it is crucial that equity investors adapt their approach and position their portfolios accordingly. The firms that will be able to navigate the challenges ahead, while maintaining growth in earnings and creating value for shareholders, will be those with robust cash flow growth, healthy balance sheets, and strong market positions. In our view, successfully identifying these traits and being more selective in equity allocations will lead to the best outcomes for investors.

By Kera Van Valen, managing director

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Damien McIntyre

As Australian banks and others begin to cut their dividends in the wake of the COVID-19 pandemic and the economic downturn, Australian investors seeking income can still generate dividend income and benefit from investment opportunities residing offshore, according to Epoch Investment Partners.

Damien McIntyre, CEO with GSFM – the distributor of Epoch’s retail funds in Australia – says record low interest rates were already impacting Australian investors in their search for income before COVID-19.

“Australian investors are already well versed in receiving dividends for income but they are typically overweight domestic equities. Many local investors – perhaps focused too much on the benefits of franked dividends – are unaware of the diversification benefit and potential of comparable dividend income gained by investing globally. But in uncertain times such as these, the diversification benefit of global equities becomes much clearer.

“In a world starved for yield a portfolio of high quality global equities is a good place to go for income when the bond yields alone are not up for the job.

“In this new investing environment, investors would do well to focus some of their attention on companies outside of Australia, those with global brands operating across multiple geographies. Investors should look to companies with solid balance sheets and resilient earnings and cash flows – such as tech, healthcare, and utilities. A greater universe of companies fitting this profile is found outside of Australia.

“Globally, it is these three sectors where we have seen resilience in earnings profile and in dividend profile in previous recessions. The expectation is that these sectors will hold up reasonably well this time around as well.”

Mr McIntyre said investors should be careful about interpreting the high level commentary about the negative impact of COVID-19 on dividends, as it can vary greatly by geography and by sector.

“Two sectors that are typically hit hard during recessions are financials – as we have already seen in Australia, they are always at the centre of the storm – as well as consumer discretionary stocks.

“Conversely, two sectors that have typically held up well in recessions are tech and healthcare. Dividends are much more stable in the tech sector. And healthcare tends to be virtually recession proof with very modest declines in earnings per share and dividends per share.”

Mc McIntyre said while looking for companies with attractive yields, it is important to not simply buy stocks with the highest dividend yields, because not all yields are created equal.

“A high yield could be the product of a one-time windfall or a collapsing stock price which may not be sustainable. To identify dividend streams that are sustainable and growing it is important to understand what drives free cash flow at individual companies, and then look for companies that can grow their operating cash flow by at least 3 per cent annually.

“Equally important is determining whether the company has a capital allocation policy that is disciplined, transparent and shareholder friendly.

“Not all businesses will face the same degree of stress from the government restrictions on social interaction, and some will continue to generate material cash flows. Others entered this period with ample liquidity to withstand a temporary demand hit.

“One other factor to consider is that, despite the deterioration of the short-term market environment, the ability of many companies to pay dividends has actually improved over recent years.

“Most firms are pursuing “capital light” business models. They are substituting technology for both labour and physical assets at a pace never seen before. With the deployment of technology, less labour and less investment in physical assets is required to generate the same level of revenues.

“Since the universe of profitable opportunities in which to invest that capital is not likely to expand at a rate greater than the savings generated from the effects of technology substitutes, companies with thoughtful capital allocation policies will return more capital to their shareholders.

“We do not expect these sound capital allocation policies to disappear as a result of the global coronavirus pandemic.”

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William Priest

The Global Financial Crisis of 2008 was a gigantic worldwide liquidity crisis that morphed into a recession but was largely treatable by monetary policy with fiscal support. Novel monetary and fiscal solutions, Quantitative Easing (QE) and the Targeted Asset Repurchase Program (TARP) in particular were put into place in the U.S.

QE was used initially to solve the overwhelming illiquidity issue of the moment. No free market solution would have worked without untold misery of unemployment and bankruptcies. The banking system could not have survived. Our federal government purchased certain assets that were killing private sector holders because of their illiquidity and placed those securities on a balance sheet that possessed an infinite maturity—that of the federal government. These policies worked, and the U.S. taxpayer even made a profit on TARP holdings.

In my 50 years of working in finance, it was the most terrifying moment I had ever experienced. The world as we knew it could have imploded. But it did not thanks to the mixture of TARP and QE.

The COVID-19 pandemic of 2020 is a very different situation. From an economic perspective, we are facing a huge demand shock, not a financial liquidity shock. Without an offset, we will then face a supply shock as unemployment rises and productive measures crumble. This important difference from 2008 must be solved with fiscal policy and not monetary policy. The latter cannot address the problem we face today. For one thing it comes at a time when corporate balance sheets are highly leveraged relative to their past and the global manufacturing base was already flirting with recession as reflected in global manufacturing PMIs.

COVID-19 has produced a huge demand shock at the same time in which we have entered a new cold war with China, supply chains are being deglobalized, and the labor arbitrage that began with the fall of the Berlin Wall in 1989 has run its course. Profit margins were peaking, manufacturing PMIs were falling and corporate debt leverage was touching new highs.

As we begin to grasp both the human and economic consequences of this pandemic, the demand shock is increasingly evident. A recession is inevitable when one considers the forces in motion and only fiscal policy can address the broadening consequences of this exploding demand shock.

Think of COVID-19 as a point on an “S” curve. Early on, the incidence of the virus expands as it rides up the S curve. Every data point is higher and the rate of change is increasing as well. At some level, we reach an inflection point. After that, the curve continues to rise but at a decreasing rate before it reaches an asymptotic state (think flat).

We still do not have a good picture of where we are on the “S” curve globally. China and South Korea appear to have passed the inflection point but that does not appear to be the case elsewhere. The key is to hit the inflection point as soon as possible and hope that we can bend the curve to something close to flat. Think of the letter “L” upside down. Achieving that will require significant social distancing now and eventually a vaccine.

The faster we flatten the line, the better for our health, but actions taken to do just that will worsen the economic outlook. This is why we need fiscal stimulus, and it will have to be big. Only the federal government can deal with this problem in order to minimize the length of any economic slowdown. We must offset the demand shock arising from the “treatments” (primarily social distancing policies) required to eliminate the virus.

Consider the following model. It is something we have used in the past to demonstrate the linkage between the real economy and the financial economy. The links between the two economies are shown below.

Real GDP is the sum of the levels of employment and productivity. The growth rate is the sum of the growth rate of the work force plus the growth rate of productivity. Add inflation to that number and you have nominal GDP.

If one holds profit margins constant, the growth rate of nominal GDP tends to equal the growth in corporate earnings over long periods of time. The valuation metric for those earnings (think P/E) is largely driven by the inflation rate as reflected through interest rates. The absence of inflation would cause one to use what economists call a “normal” interest rate.

Here is where a lot of things changed during the last decade. QE dropped or even eliminated the “normal” rate, causing the present value of financial assets to soar. The idea was that the higher level of financial asset values would induce higher GDP because higher wealth combined with the marginal propensity to consume (MPC) would accelerate growth in employment and productivity and lead to overall GDP growth accelerating. While it was helpful to the economy, even if not to the degree that was hoped for, it was fabulous for financial asset valuations.

Now, let’s look at the model through the lens of the demand shock induced by COVID-19. Services represent more than 50% of the U.S. economy, and services require human interaction. Social distancing will impair that activity and eventually result in lower employment and productivity. As these components decline, so will real GDP, leading inevitably to a recession.

Monetary policy cannot address this problem, but fiscal policy can. The “G” component in the C + I + G + (X-M) = GNP equation must be expanded a great deal. Only fiscal policy can accomplish this end. For the U.S., a badly needed infrastructure stimulus could be put into place. With Treasury rates at all-time lows, it would be easy to finance. (Yes, we would be adding to the “debt mountain,” but let’s hold that issue for the moment.) There are two big sources of demand for the debt issuance: foreigners and the Social Security System regardless of the low rate levels that exist at the moment. (That argument will be presented in a future paper).

If the only tool we use is monetary policy it will fail badly. The demand shock will lead to a supply shock as unemployment rises and productivity falls. One must use fiscal policy to solve this problem even if means mailing a check to households every month who are suddenly left without income earners because of the shock emanating from the social distancing policies required to defeat biological effects of the virus.

The Fed has cut rates to zero, but it will not be enough. If fiscal policy is deployed in a timely (now) and efficient manner, the future shape of the economy can look more like the letter “V” than the letters “U” or “L.” The equity markets will reflect that shape as well.

By William W. Priest, CFA , Chief Executive Officer, Co-Chief Investment Officer & Portfolio Manager

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In this newly created role, Mr Schipper will oversee Epoch’s newly opened office, as the firm builds its presence and visibility with investors in these growing markets.     

Mr Schipper brings to the role a wealth of experience in working with a range of clients and investment solutions. He has worked for some of Australia’s most notable institutions, most recently Nikko AM, where he was the head of Australian distribution. Prior to that he held roles with IFM, Colonial First State, HSBC and Perpetual Trustees. He holds a post graduate diploma in finance from the University of Melbourne and a Bachelor of Business from Victoria College/Deakin University.

“Opening a full-time office with an experienced leader like Eddy underscores Epoch’s commitment to our Australian and New Zealand institutional clients, and especially to our relationship with GSFM,” said William Priest, Epoch co-founder, Chief Executive and Co-Chief Investment Officer.  

Priest added, “In addition to his knowledge of the specific needs of investors in that region, Eddy brings an abundance of enthusiasm to what we expect will evolve into a growing market segment for Epoch. We are excited that he is joining our firm.”

GSFM, which has partnered with Epoch since 2007 to distribute its Epoch Global Equity Shareholder Yield fund in the Australian and New Zealand markets, will continue to be responsible for the retail distribution of the funds.

Damien McIntyre, CEO of GSFM, said this is an exciting step in the development of the Epoch business in the local market at a time when yield is a particular focus for investors.

“Since first starting to work with Epoch over 12 years ago, we have grown the local funds under management to $2.58 billion. We are looking forward to working closely with Eddy to further build on this strong growth, and continue the distribution of Epoch’s funds to retail investors,” he said.

“It’s a very exciting opportunity for me to join a firm with such a tremendous track record, and reputation in the investment marketplace,” said Eddy Schipper. 

He added, “I look forward to the opportunity to help develop Epoch’s presence in Australia and New Zealand and further strengthen and deepen Epoch’s existing investor relationships.”   

Epoch is an asset management firm that provides global and regional equity strategies for institutional and intermediary clients worldwide. Epoch’s investment approach is based on fundamental research and seeks to invest in companies that can grow free cash flow and allocate it effectively for the benefit of shareholders. Epoch’s culture is investment led, collaborative and designed to help clients achieve their investment objectives. Epoch was formed in 2004 by an experienced group of investors and is the steward of $53 billion (AUD) in client assets under management as of June 30, 2019. Approximately $3 billion of those assets are managed for Australian clients.

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Steven Bleiberg

Investors need to remember the basics of what makes a company successful and not focus solely on theories or factors when building portfolios, according to a recent paper by New York-based investment manager Epoch Investment Partners.

In the paper, The Limits of Theory, Epoch portfolio manager Steven Bleiberg looks at Modern Portfolio Theory (MPT), which was first developed in the 1950s, and why it may be hindering investors looking for active management.

“We believe that MPT has been a positive development in helping people to better understand investing. But like any theory, MPT is only a model of the way the real world works; it is not the real world itself.

“It is our contention that over the last 50 years, some investors have become so enamored of the theory that they have lost sight of the real world underlying the theory.”

He says that in MPT, stocks are viewed not as businesses, but as collections of factor exposures.

It has also given rise to the idea that a market index is an optimal portfolio, rather than simply a broad measure of the market.

“This has led people to believe that it is a positive good to make no effort to judge whether a business is worth owning,” he says.

“We need to remember that in reality individual stocks rise and fall because of the success or failure of the underlying businesses; that the market as a whole rises or falls because of the ability of the average business to generate a premium over its cost of capital; and that not every publicly traded company is a business worth owning.”

Mr Bleiberg points out that investing is not a theoretical exercise; it’s about understanding what makes one business succeed while another one fails and that ultimately, there are limits to what MPT can do to help us be successful investors.

In particular, he looks at how the focus on factors has affected investing approaches.

“At the end of a given time period, an analyst versed in MPT will take the returns that various stocks have experienced, regress them against the ‘factor exposures’ of the stocks at the start of the period, and produce a set of ‘factor returns’ – that is, the return associated with a one standard deviation level of exposure to each factor in the risk model.

“But many investment practitioners have become so enamored of this theoretical framework that they reverse cause and effect in the way they think about the world. They seem to think that a stock did well because it had exposure to certain factors that did well, as if the factor returns have an independent existence of their own out in the cosmic ether, apart from the success or failure of the underlying companies.

“However stocks are more than a collection of statistics such as mean return, variance, or a set of factor exposures.

“Their success or failure as businesses, which is dependent on their ability to meet the needs of customers and to allocate their cash flow sensibly, ultimately drives their stock price higher or lower.

“And it is the success or failure of actual businesses in the real world that creates the theoretical factor returns through the resulting stock price movements. That is, company stock price movements drive factor returns; factor returns don’t drive company stock price movements.

“Or to put it yet another way, markets don’t reward or punish abstract factors; they reward or punish companies because of how well or poorly their business is doing, and that in turn creates what we end up measuring as ‘factor returns’. But we should never lose sight of the fact that those factor returns are a derivative. They are not the starting point.”

“We should never get so caught up in a model that we lose sight of what investing is really all about in the real world. Successful investing in equities is about identifying companies that create value for their owners by earning high returns on the capital that they take from those owners and invest in their business.

“As helpful as it is to have all of the insights that MPT offers – and it offers many – an investor still has to understand the ‘why’ behind a successful business,” he says.

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Epoch believes fundamentals remain strong and maintain a positive economic outlook.

The historic tax laws that were passed in the United States in December 2017 herald a significant boon for US corporates and the broader US economy. In this article, John Tobin, managing director and portfolio manager at Epoch Investment Partners, shares the firm’s views on what these changes mean for the macro environment and global investors.

The tax reform bill, which was signed into law on 22 December 2017, is the most notable change in the US tax code since 1986 and achieves many of the long-standing objectives of the Republican Party. From Epoch’s perspective, it is extremely important in terms of its effects on the economy and how the company will evaluate investment opportunities going forward, as well as what it might mean for some of the companies already invested in.

From Epoch’s position as an investor and looking more broadly at the economic impact, it’s the corporate tax reform that’s most important – while there is a personal tax reform component, this is not the game changer. Interestingly, while business tax changes are permanent, changes for individuals expire.

What tax reforms mean for companies and investors

These tax reforms are good for business; after all, the tax rate has moved from 35% to 21%, providing companies with a permanent increase in trajectory of their net earnings and cash flow. When you consider that the stockmarket is a forward looking discounting machine, it is no surprise that the market reacted very positively to these reforms.

Figure one outlines the differences between the old and new tax code; in all, the reforms are most likely to boost earnings and free cash flow. Having said that, the reforms came together very quickly, so it’s likely there will be surprises and unintended consequences as the changes are implemented.

A major change is the treatment of non-US earnings. The old system kept money offshore – although earnings were still taxable at 35%, the previous tax laws allowed companies to defer them indefinitely, and not pay tax until those earnings were repatriated. As a result, the balance sheets of many companies carried expanding tax liabilities.

This is no longer possible. Companies now must pay tax on all undistributed foreign earnings, whether they choose to repatriate them to the US or not. ‘Deemed repatriation’ means that companies must determine their accumulated, unrepatriated foreign earnings and start to pay tax on those earnings. The reform has offered a one-off tax payment for repatriated – or deemed repatriated – earnings at 15.5%. Companies have eight years to pay tax liabilities on foreign earnings and cash currently held abroad which, as illustrated in figure two, has grown to approximately US$2.5 trillion since the early 2000s.

Many US companies have held cash offshore, which means earnings that have not been reinvested in the business. This cash is concentrated in 10 companies, mainly technology businesses, which generate a lot of cash through global operations, and faster than they can reuse it. A snapshot is provided in Figure three.

The Joint Committee on Taxation calculates that Treasury will receive $340 billion over ten years from deemed repatriation – important, because these tax cuts are going to create a trillion-dollar hole in the US budget.

Which companies benefit from tax reform?

While all companies will benefit from the lower tax rate, some benefit more than others. For example, those businesses that have a significant capital expenditure requirement can now expense capex in the year of purchase, rather than over several years.

Domestic US companies that generate most or all earnings in the US pay 21% tax from 1 January 2018. Examples of companies that benefit include:

• Healthcare companies, which tend to deliver their services in the boundaries of the United States – examples include biotech business AbbieVie and United Healthcare
• Regional banks and other financials such as Wells Fargo.
• Telecommunications companies, such as AT&T, which are double beneficiaries because they also tend to have high capital expenditure.

Also to benefit are non-US companies with significant earnings in the US; that portion of their earnings is now taxed at 21% instead of 35%. Includes industries such as:

• Aerospace – both Airbus and BAE systems do a significant amount of business in the US
• Global auto manufacturers – Daimler, BMW, Honda, Toyota – each of these has significant sales and earnings in the US
• Global financial services firms such as AXA and Allianz, which have many US-based clients, and therefore significant US-sourced earnings.
• Global pharmaceutical giants such as GlaxoSmithKline, AstraZeneca and Roche – a large part of their business is in the US market, so they too will benefit from the reduced corporate tax rate.

So, it’s a good thing for corporate America and a good thing for investors, particularly those using a shareholder yield strategy, which is premised on companies that have strong free cashflow – companies now have greater cashflow with which to reward shareholders through increased dividends, share buybacks and paying down debt.

Where will free cash flows go?

According to Epoch, there are five possible uses of free cash flow, as illustrated in figure four. Firstly, businesses can invest to grow organically, or to grow inorganically by acquiring businesses.

Epoch believes most will go to the owners of the business – the shareholders though dividends, share repurchase or debt reduction. From Epoch’s perspective, it is less likely to be used to fund capital expenditure or merger and acquisition activity because cheap debt has been readily available for many years and companies that want to do this have done so.

Epoch’s view is supported by the findings from a survey undertaken by Bank of America Merrill Lynch (BAML) in which CEOs were asked how they would use additional cash flow – refer figure five. Paying down debt and share buybacks topped the charts; interestingly, funding pension liabilities was also mentioned, paying debt in another form.

Equity demand by corporations – or, in other words, share repurchases – has been increasing since the Global Financial Crisis (GFC). Figure six shows the difference between forecast equity demand pre and post-tax reform. Epoch agrees that a lot of the money freed up by tax reform will be returned to shareholders in the form of share buybacks.

The world is changing, and technology is changing the way businesses operate; Epoch refers to this as a ‘capital light’ environment, where businesses don’t need to spend as much capital to maintain and grow their businesses. Capital spending as a proportion of corporate profits is declining. This view has been discussed in detail in recent articles Tech is the new macro – part one [https://adviservoice.com.au/2017/09/cpd-tech-new-macro-impacting-three-components-return-equity/] and Tech is the new macro – part two [https://adviservoice.com.au/2018/01/cpd-tech-new-macro-part-two/]

In the early 1970s, approximately 75% of a company’s earnings were allocated to capex – today, it’s more like 30-35%; this is a structural change, not a sign that businesses are failing to recognise business opportunities. Epoch believes that advances in technology mean less hard assets are required to increase payouts to shareholders in the form of share repurchases and dividends.

Case study

United Parcel Service (UPS) is held in Epoch’s shareholder yield portfolios because it pays an attractive dividend every year and buys back stock every year – in short, it has a very clear capital allocation policy.

UPS has been a leader in adopting technology. Its business involves the movement of thousands of items around the globe. Trucks full of boxes go to a distribution centre…from there smaller trucks head to another distribution centre…from there, parcels are loaded onto another smaller truck that takes the item to people’s homes or offices.

Significant logistics are involved, and UPS learned long ago that the best way to reduce their costs was to automate the process as much as possible – as such, the company invested in automating warehouse and distribution centres.

Profit goes up to the extent they can replace workers with machinery and automation, they use assets more efficiently and because they get more sales dollars out of existing assets, their asset utilisation is better. Accelerated use of technology by UPS has increased profit and asset utilisation, which means the company requires less equity to keep things going – therefore equity is freed up to be returned to shareholders.

The macro environment

Growth around the word is increasingly synchronised – as illustrated in figure seven, variability of GDP across countries is at its lowest since 1961. This is significant because a solid global cycle is a major positive for earnings growth, regardless of recent volatility in markets.

Although businesses need to invest less in a capital light world, there has been a marked upturn in capital spending. As shown in figure eight, it was a well-established upturn before tax reform, one which will now be turned up.

Add to that, US exports and industrial production are also on a strong growth trajectory – this growth was up before tax reform and will be well established post tax reform – these things have a way of being self-reinforcing. See figure nine.

Interest rates have a way of spooking the market, which is what happened on Friday 2 February. The employment report was strong, with an unemployment rate of 4.1%, which is close to full employment. The market reacted to hourly earnings growth, which led people to be concerned they are underestimating inflation risks and therefore, the likely interest rate trajectory.

While expecting a moderate increase in rates going forward, Epoch believes that even with synchronised global growth, it is relatively low growth – and a low growth world is generally characterised by low inflation, even if getting close to the 2% target adopted around the world. This then flows through to a relatively benign interest rate environment.

As illustrated in figure ten, Epoch believes this process will be gradual and it will be well telegraphed – by the Fed and other central banks around the world. There will be return to policy normalisation – need to move from quantitative easing (QE) to quantitative tightening (QT).

In all, despite the increase in market volatility in recent days, Epoch believes fundamentals remain strong and maintain a positive economic outlook. Central bankers have successfully staved off deflation, while inflation remains below 2% in the G7 and has declined markedly in emerging markets.

Although there is some upward pressure in the US due to labour markets, it is partially offset by technology driven deflation – a tug of war that keeps inflation under control.

Importantly, the macro backdrop remains positive and corporate fundamentals are strong, particularly for those companies based in, or doing business in, the US. Epoch believes that equities continue to be a good long-term investment but difficult to predict in the short-term; the team continuously monitors market developments but has not altered its view or made material changes to overall portfolio positioning.

———

The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. References to any security do not constitute a recommendation to buy, sell or hold such security. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2018 Grant Samuel Funds Management

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John Tobin

The timing of President Trump’s Tax Cut and Jobs Act – coinciding with the most synchronised global economic recovery since the 1950s – will boost company earnings globally during 2018, despite recent market volatility, says John Tobin, portfolio manager with US based Epoch Investment Partners.

“The variability in GDP growth across countries is at its lowest point in over 50 years. This solid global growth cycle is a major positive for economies and company earnings growth.

“Capex has rebounded strongly and US export and industrial production has risen significantly. Meanwhile, we are expecting the transition globally, from quantitative easing to quantitative tightening, to be slow, gradual and well telegraphed.

“In fact, despite anticipated QE measures, financial conditions will remain extremely loose. In the US, the Fed’s financial stress indicators suggest markets are still awash with liquidity.”

“The lower tax rate regime in the US will impact this liquidity, and along with US companies, beneficiaries of the lower tax rates will also include non-US companies with significant earnings in the US – including automotive manufacturers, global financial and pharmaceuticals, along with companies operating in the aerospace and defense industries,” Mr Tobin says.

These tax reform initiatives, along with the economic recovery being experienced around the world, bode well for those companies already generating free cash flow.

“The most significant changes of the recent US tax reforms relate to business taxes. Lower taxes mean higher company earnings and cash flow, and these changes permanently raise the path of after-tax earnings and cash flow, which is unequivocally positive for share prices.

“It is a good move for shareholder yield.

“History suggests the extra cash from corporate tax returns will flow mostly to shareholders through dividends, buybacks and debt reductions, rather than other sources.

“This environment will be favourable for equity strategies focused on identifying companies with growing free cash flow and a track record of returning excess free cash to shareholders.”

In terms of sector allocation, Mr Tobin says Epoch Investment Partners remains overweight in telecoms, utilities, consumer stables and energy.

“The key to producing superior risk-adjusted equity returns is the identification of companies with a consistent ability to both generate free cash flow and to properly allocate it among internal reinvestment opportunities, acquisitions, dividends, share repurchases and debt repayments.

“The focus needs to be on companies which return a proportion of their market capitalisation to shareholders on a regular basis, while still reinvesting enough in the business to grow operating cash flow,” Mr Tobin says.

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The funds are managed by New York-based equity manager, Epoch Investment Partners, and invest in a diversified equity portfolio of listed global companies that have a history of attractive dividend yields and positive growth in free cash flow.  They were launched in Australia in 2008 for retail investors and are distributed by Grant Samuel Funds Management (GSFM).

Damien McIntyre, CEO of GSFM, said the highly recommended rating from Zenith is a testament to the quality of Epoch team and the strength of its differentiated approach to equities investment.

“Zenith’s rating underscores the value of a dividend strategy in the current environment, with investors continuing to seek income but with an increasing focus on quality.

“We believe that the Epoch strategy is unique in the Australian market, offering investors access to a diversified portfolio of high-quality companies that have a track record of generating growing levels of free cash flow, while simultaneously rewarding shareholders with a progressive dividend, supplemented by share repurchases and debt reduction.

“There is always a place in portfolios for quality, and now is not the time for long-term investors to turn away from a dividend focus,” Mr McIntyre said.

In its report, Zenith stated: “Zenith views the portfolio construction process to be unique as the Fund is not purely chasing historical yields, instead focuses on the future sustainability of a company’s yield, in addition to actively diversifying the source of income yield by limiting each holdings contribution. Zenith views this unique approach as a point of differentiation for the Fund.

“On this basis, we believe the Fund is ideal for investors seeking an international equities fund generating consistent income returns and solid levels of capital growth over the longer-term. Due to the Fund’s high income focus and strong defensive qualities, Zenith recommends that the Fund be used as a part of a diversified international shares portfolio.

“Zenith maintains confidence that the Fund remains positioned to achieve its investment objectives over a full market cycle.”

Zenith also said: “The Epoch investment team is led by Bill Priest who has over 50 years of investment experience and is one of the most experienced global equity investors Zenith has reviewed.

“Priest leads a highly experienced and well-resourced investment team consisting of 45 members (as at 30 September 2017) including portfolio managers, analysts, traders and client portfolio managers.

“In summary, Zenith believes that the team is well credentialed to successfully manage this Fund and that the team based structure aids in mitigating succession risk.”

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This article, based on a presentation given to advisers on 7 June 2017 by John Tobin, portfolio manager with Epoch Investment Partners (Epoch), looks at the global economic environment and expectations for growth in the coming years.

The macro environment

According to John Tobin of Epoch, the global economy is doing “reasonably well” and the economies of developed nations are favourable. Despite recent shocks – Brexit in the United Kingdom, the collapse in oil and commodity prices that hurt Canada and Australia in 2015, and the ongoing expectations of a hard landing for China’s economy over the past few years – overall, there is a benign economic environment around the world.

An interesting trend is the synchronicity among developed economies that has resulted in the convergence of global GPD rates. As illustrated in Figure one, global GDP growth rates are converging around the two per cent mark for mature economies; Epoch expects developing economies to have GDP growth of three-to-four per cent.

While not the stellar growth seen in previous years, positive GDP growth is an encouraging scenario – so, are there things to be worried about?

There’s plenty to be worried about!

The key market risks ahead focus on the “known unknowns”, particularly risks brought on by the Trump Presidency, as well as the economic outlook for China. The downside risks posed by Donald Trump’s policy agenda include higher interest rates, increased protectionism, anti-immigration policies and geopolitical shocks. The possibility that trade relations will deteriorate substantially is a real threat to the US and other economies. Policies that add stimulus to an economy operating at, or close to, full employment will put inflationary pressures on the US Federal Reserve, which will in turn put pressure on US interest rates.

There are upside risks, which include tax reform, regulatory reform, infrastructure spend and faster credit growth. While tax reform and regulatory reform are expected, it is viewed by Epoch as more likely to be incremental than the game changer advertised during the election campaign.

The US corporate tax rate is high compared to many developed countries, and particularly high when compared to developing nations. As a result, even moderate relief in corporate tax rates would be supportive for companies and financial markets.

Epoch’s modelling shows that a five-percentage point reduction in the effective marginal corporate tax rate in the US would add $8-$10 to the earnings per share (EPS) of the S&P 500.

The impact of these unknown factors could be substantial, particularly when coupled with the fact that geopolitical events are continuing to create potential for uncertainty and further market volatility.

Meanwhile, outside of the US…

While the US is focused on the Trump administration, there are other global factors to monitor.

The situation in Europe is improving. Although Macron successfully defeated the right-wing agenda in France’s recent election, the populist forces and voices have not gone away. The unexpected outcome of the UK election will add further uncertainty to the way Brexit negotiations will impact both the UK and Europe.

Epoch believes the UK economy has held up well because the Brexit process has barely started; and, like many divorces, it is not expected that Brexit will be an entirely amicable separation. As the separation progresses, it is unlikely to play out smoothly without any economic consequences and associated impacts on financial markets and the UK economy.

China remains a big concern. It’s the world’s second largest economy, a major contributor to growth and while some growth is evident, there remains concerns about its sustainability. Figure three shows China’s contribution to world GDP growth, which has been considerable since 2010, rising from just over 20 per cent to just under 30 per cent in that period.

However, as illustrated in figure four, the rate of growth of China’s GDP is decreasing. From a high of 14 per cent GDP growth in 2007, the International Monetary Fund (IMF) forecasts China’s growth at just over 6 per cent by 2018.

Although China is trying to position its economy away from a dependence on exports and investments, to have a more balanced GDP with a reliance on consumption, it may be a difficult transition. The IMF projects a continuation of the gradual downward growth trajectory and a reminder of the potential for a hard landing in the future.

Two percent is the new four percent

A topic of many discussions at Epoch is the notion that ‘two percent is the new four percent’. The fundamental drivers of economic growth come down to two factors: employment growth and productivity. Across the developed world, each country faces the same demographic headwinds…populations are not growing, labour force growth is low, and productivity growth has slowed dramatically. As illustrated in figure five, relatively modest productivity growth plus slowing labour growth result in declining output and lower growth.

Lower GDP levels will naturally have a flow on effect to global equity markets, as will interest rate movements. While interest rates remain relatively low around the world, and are expected to remain so, the Federal Reserve is moving to gradually normalise interest rates.

Although the IMF projections (figure six) look positive and show modest increases in GDP for 2017 and 2018, Epoch is mindful that there are any number of exogenous factors that could interrupt this, such as:

• Terrorist attacks
• ‘Policy terror’ – for example, the Fed raises rates too quickly and puts the brakes on, or the European Central Bank (ECB) gets ahead of itself and starts to remove policy accommodation too quickly or too aggressively, that could be the policy mistake that upsets the scenario
• A Donald Trump led policy shift, such as protectionism, that could lead to a trade war that has negative consequences for world trade.

Financial markets at an all-time high

Globally, financial markets are riding high. As indicated in figure seven, the S&P500 and MSCI World Index are at all-time highs, while the MSCI Emerging Markets Index is the highest it has been in quite a few years. Where will it go from here?

There are three factors to consider when analysing the return from shares – how much of the return is due to earnings growth, how much is due to dividends paid, and how much is due to the expansion (or contraction) of price/earnings (PE) multiples?

As illustrated in figure eight, the period from 2012 to 2016 has been anomalous when it comes to the composition of sharemarket returns. Epoch’s analysis of the S&P500 and the MSCI World Index over this time found that the percentage of return attributable to the expansion of PE multiples is significant: almost 70% of the S&P500 growth over this period resulted from the expansion of multiples, while the rise in the MSCI was almost 85% composed of PE expansion.

Looking more closely at the MSCI (middle pie chart), earnings growth went down over this time, and yet stocks rose.

Over the longer term (third pie chart, figure eight), the true drivers of share price growth are earnings growth and dividends. Historical analysis shows these are the long-term drivers of growth and returns.

Epoch’s research found that while earnings growth made up 17.3 per cent of returns in the S&P 500 between 2012 and 2016, this is expected to rise to 50.4 per cent over the next 10 years. Similarly, dividends are expected to increase from 13.9 per cent of equity market returns to 40.7 per cent.

The rise in global sharemarkets has been driven by PE multiple expansion, which has, in turn, been driven by monetary policy – low to negative interest rates and quantitative easing programs that pushed interest rates to global lows. When you push the discount rate down, it causes PE multiples to rise.

Just as equity multiples expanded during quantitative easing (QE), there will be a gradual contraction of multiples as economies unwind their longstanding QE policies. In this environment, equity drivers will return to normal, with dividend and earnings likely to make up a larger component of returns.

In summary

1. The long-term outlook of mid-single digits remains intact with main drivers of growth unchanged (2% is the new 4%).
2. Interest rates remain relatively low around the world even as the Fed gradually normalises; the central bank has carefully embarked on a tightening program, while other central banks have yet to commence. They are where the US was two years ago – talking about how and when to reduce QE and accommodation.
3. The market will be less impacted by broad-based multiple expansion; dividend and earnings are likely to be larger components of returns and be the fundamental drivers of returns. Investment will focus on identifying companies with those characteristics, as they will drive returns in the future.
4. Geopolitical events create potential for uncertainty and further market volatility. This will be a constant companion going forward.

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2017 Grant Samuel Funds Managemen

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