Gervais Williams, Head of Equities at Premier Miton and co-manager of the Diverse Income Trust, shares his view on the significance of dividends in this Q&A.
For information purposes only. Any views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
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The Diverse Income Trust launched in 2011 with the goal of providing shareholders with an attractive and growing level of dividends coupled with capital growth over the long-term. It does this through investing in UK-listed companies that have the potential to generate above-average dividend growth. Gervais Williams manages the trust’s portfolio with fund manager Martin Turner.
Who better to ask about their importance than a fund manager known for focusing on delivering returns via good and growing dividends?
First things first, what are dividends and why do they matter?
Dividends are a proportion of company profits paid out to shareholders in cash as a reward for their investment. They’re usually paid on a per-share basis.
Gervais Williams (GW) says: “Listed companies, those that have issued shares through a stock exchange, do not just succeed by generating growing profits. Many pay good and growing dividends so they can accelerate their growth via additional finance raised from external shareholders. The ability and willingness of a company to pay steady dividends is seen as evidence of financial strength.
“During economic recessions, when most companies are short of cash, those paying good and growing dividends can often continue to raise additional funds.
“The most obvious benefit for the investor is that dividends can pay a regular income stream, with income-generating investments being particularly appealing to retirees.”
In certain market conditions, companies may reduce or even suspend paying dividends until conditions improve. This will impact the level of income distributed by the trust.
How important is the compounding effect of dividends?
Even income investors can take advantage of the power of compound interest from dividends reinvested. While the benefits of compound interest, earning interest on interest earned, are usually associated with investing early in life, retirees can make their money work for them too. For the income investor, investments in dividends can help cushion declines in share prices and are an opportunity for income growth.
GW: “Stock markets, where companies raise money by selling shares, typically fluctuate considerably throughout the year. The value of a fund minus any liabilities and expenses (also known as Net Asset Value or NAV) can increase by a large percentage or suffer setbacks over the course of the annual investment reporting cycle. Over the longer term, fund rises in some years are typically offset by falls in others.
“Meanwhile, significant cash dividends can rack up over time to become a greater and greater financial sum. So, over the longer term, say ten years, a significant stream of cash dividends may end up being most of an income fund or trust’s total return (or aggregate income), outpacing the growth of its overall NAV.”
What are the advantages of an equity income strategy over the longer-term?
As well as the generation of a regular stream of income through dividends, another benefit of investing in a strategy focused on generating income through listed companies is the potential for growth. Gervais Williams explains the opportunities he sees right now.
GW: “The years since 2011 have been marked by unusually strong stock market growth, especially in the US. Overall, most equity income strategies have reported a series of NAV rises. So, trusts which deliver a major portion of return via the accumulation of a stream of dividends, have been outpaced by those with a greater focus on NAV appreciation. We consider this unusual and vulnerable to change.
“More recently inflationary pressures have become increasingly unsettled. If this leads to recessionary conditions, companies requiring further finance for their businesses could find themselves under pressure, while those already generating extra cash should prove more resilient.
“With globalisation fading, a trust (a public limited company traded on the London Stock Exchange) or fund that can deliver a major proportion of its return via the accumulation of dividends may not just be well set to generate an attractive return over the longer term, but if stock markets are less buoyant may also outpace those focusing on NAV appreciation.”
What is the “small-cap effect” and why invest in a proportion of listed smaller companies and not just large ones and so-called mega-caps?
For the managers of the Diverse Income Trust, the search for cash generative companies is expected to favour the smaller UK-listed firms. Mega-caps are the largest companies in the investment universe as measured by their market capitalisation of $200billion or more.
GW: “Mainstream stock markets have performed so strongly for so long that low-cost passive strategies (sometimes called “buy-and-hold”), where portfolios’ allocations are solely determined by the scale of the individual stocks in an index, have become popular.
“This has led to a self-feeding loop with ever larger financial flows driving up technology stock valuations, so their returns have greatly outpaced all others. Meanwhile, withdrawals have depressed smaller companies’ returns, amplifying the period of underperformance.
“The performance of mega-caps has been extraordinary over recent years. However historic stock market data highlights that this is most unusual.
“Over the longer term, smaller companies typically outperform larger companies, a pattern academics refer to as the ‘small-cap effect’. Overall, most US technology mega-cap valuations appear overstretched currently, such that even a minor change in trend might now drive a major reversal in their returns. With global smaller companies’ valuations unusually low, we and the wider market are now starting to anticipate a major performance catch-up.”
Why focus on UK dividends?
GW: “Although the UK stock market has generated returns that compare favourably with inflation over the decades, its returns have been outpaced by international stock markets with greater cohorts of technology growth stocks that have drawn upon the buoyant markets to deliver accelerated growth.
“Overall, this has left the UK stock market standing on an unusually low valuation compared with the US mega-cap technology stocks, for example.
“In our view, the UK stock market has the potential to become one of the best performing global stock markets over the coming decade. This might occur at a time when many other stock markets are delivering comparatively weak returns.
“We believe a portfolio of UK-listed companies, including numerous smaller firms, is an advantage. If globalisation continues to fade, we believe that most global investors will reallocate into equity income stocks, with the UK stock market being the prime beneficiary.”
