Investment Watch

Can you find certainty in an uncertain market?

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Equity markets this year have been dominated by volatility and uncertainty, requiring special focus from investors.

Concerns around economic growth, geopolitical instability and the threat of higher interest rates in the US have all played their part in creating a sense of unease about where markets are heading.

In these conditions it is very difficult for investors to identify reliable sources of return. Where is it possible to find any kind of stability?

What is often overlooked is that share prices are only part of the equation when it comes to equity investing. If one is focused on this aspect, current conditions can seem very disconcerting.

However, things look less daunting if one focuses on the other component of equity returns – dividends. Despite what share prices might be doing, if you can identify companies that are reliable dividend payers, you are securing some measure of certainty.

Dividend growth is also the biggest driver of capital growth over time. That means the more predictable dividend growth one can achieve, the more predictable capital growth will be.

To give some idea of just how important dividends are, consider that the FTSE All-share Index on the London Stock Exchange has produced a capital return of just 13% over the last ten years. However, if one adds in dividend payments, the total return has been 41%.

Identifying the right stocks

How, though, do you go about finding companies that are going to pay sustainable dividends going forward? With the caveat that when investing in equities you can never be 100% certain of anything, there are some key characteristics you can look out for.

The first is to limit yourself to well-established, large-cap companies listed on major exchanges. Start-up and smaller companies bring too much uncertainty.

Secondly, there must be an existing track record of dividend payments and a balance sheet that can support dividend distributions in the future. The company must also have prospects that will enable them to continue to grow dividends over time.

The third consideration is whether the company is well placed in the current economic environment. Locally, for instance, Foschini and furniture retailers like Lewis have been solid dividend payers, but their reliance on credit sales makes their business models less secure in an environment where the consumer is under pressure and interest rates are rising.

“We prefer companies that offer basic necessities, like Unilever and Colgate-Palmolive,” says Lourens Coetzee, investment professional at Marriott. “We also have exposure to the healthcare, tobacco, beverage and banking industries.”

Linked to this is the fourth consideration – screening out industries that are deeply cyclical, such as mining, where it is very difficult to know what next year's earnings or dividends might look like. Marriott also excludes industries that are highly unpredictable, such as IT and technology.

“It is very difficult for us to know where the next big idea is going to come from,” Coetzee explains. “A good example would be if you had compared Apple and Sony in the late 1990s. Very few people knew Apple, and Sony offered market leading products like the CD walk-man and PlayStation. But today through developing products like the iPod and iPhone, Apple is twenty times the size of Sony. The lesson is that we don't know who the next Apple is going to be.”

Finally, it is important to look at any company-specific risks that may put future earnings and dividend growth at risk. This includes looking at issues such as whether margins are steady and how debt is being funded.

The companies that would make it through all of these filters generally tend to have five characteristics: they fulfil a basic need; have strong brands; enjoy pricing power; operate in growing markets; and have diversified earnings.

Pay the right price

While analysing stocks on this basis will help you identify those that are most likely to be reliable dividend payers, that doesn't mean you should rush into buying them all straight away. It is still important to make sure you are not over-paying.

Especially in the current market, quality companies like these with the ability to grow earnings and dividends over time have been heavily in favour and in many cases their share prices have been pushed to expensive levels. It is therefore important to be able to identify those that still offer reasonable value.

“If you can ensure that you are in companies that can grow dividends and earnings in the next few years you are in a good space,” Coetzee says, “but price is still important. You should always try to avoid paying too much for an investment, and you have to be careful because people have been paying up for quality.”

The two key metrics to look at are dividend yield and price-to-earnings. An above average dividend yield and a below average price-to-earnings ratio would indicate that you are paying a below average price.

And currently the best place to find those opportunities is offshore.

“If you compare what you can get in South African to the type of companies you can buy on international markets like Coca-Cola, Johnson & Johnson and 3M, you are getting a lot more offshore,” Coetzee argues. “The dividend yield on these kinds of companies is around 3.5%, whereas it's 3.0% here, and the earnings are more diverse and secure. You are also getting those companies at a cheaper entry point.”

He says that Marriott is currently struggling to find locally-listed companies that have enough certainty around future earnings and dividend growth. They have therefore increased their offshore exposure.

“For example, we have dis-invested from MTN and Vodacom in favour of Verizon and Vodafone,” he explains. “We have also taken out Tiger Brands for Nestlé, Kellog's and Unilever. We believe that has improved the quality of the portfolio because we have improved the outlook from an earnings and dividend growth perspective.”

                                                                                                                                                                                      by Patrick Cairns

(The article first appeared on the Moneyweb website.)

Also read: Property & Wealth



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