In yield terms, though, the market seems to have more valuation support. The forecast dividend yield for the FTSE All Share Index is 3.68% at the time of writing, according to Bloomberg. UK Equity Income funds are expected to deliver a yield in excess of that of the market and we believe we can build a portfolio that can deliver a sustainable yield of about 4% at inception. That is an attractive return in its own right, particularly when compared to the income available on cash, Gilts or high quality corporate bonds.
The real attraction of equities, however, is in the growth that dividends can provide. Equities are real assets – companies operate in the real economy and, as such, they are typically able to increase prices over time in line with or slightly ahead of inflation. In turn, this means dividends rise over time to protect investors against the eroding effect of inflation. Ultimately, it is this “real” quality that has allowed UK equities to deliver superior long-term returns to other asset classes.
|REAL INVESTMENT RETURNS BY ASSET CLASS (% PA)
Source: Barclays Equity Gilt Study 2014
Clearly, in the current challenging economic environment, some companies may struggle to grow their dividends, others may struggle to pay a dividend at all. It is important to be selective. We need to be convinced that the companies that we invest in will not only pay a decent dividend but also have the ability to grow that dividend sustainably over time.
Admittedly there are fewer companies than a few years ago that are in this position but, crucially, there are enough to build a diversified portfolio. And we are very confident that such a portfolio can deliver a very attractive long-term return.
In its simplest form, the total return from an equity investment will be a product of dividend yield + dividend growth. Theoretically speaking, if an equity yields 4% and provides dividend growth of 4% per annum, all else being equal, its total return will be 8% per annum. Of course, in the real world, all else isn’t equal – valuation changes can significantly disrupt this simple theoretical model, particularly in the short term. Nevertheless, in the long term, fundamentals like dividend growth matter and that is why we focus on them.
This is why we are optimistic that we can find value for investors. We believe we can build a portfolio that can deliver a yield of c. 4% per annum. We believe this portfolio will be capable of delivering modest, mid-single-digit dividend growth per annum. According to our simplistic, fundamental view of the world, this should result in a high-single-digit annualised total return. That is our long-term expectation and we are confident we can deliver. In a low-growth, low-return world, we believe a high-single-digit return will be a very attractive outcome for investors.