The Merits of a Global Equity Income Approach

Transcription

1 leadership series market research April The Merits of a Global Equity Income Approach Two major U.S. bear markets during the past decade and a significant increase in volatility during the past five years have created new challenges for many investors. Historically low U.S. investment-grade bond yields now cause many U.S. investors to seek higher income outside of traditional fixed-income sources. Accelerating central bank money printing in the developed world may also cause many U.S. investors to be wary of inflation, driving a search for income that can grow in real terms, especially relative to their fixed income alternatives. Against this backdrop, U.S. investors seeking lower-volatility equity investments and/or higher-yielding assets may consider the merits of a global equity income approach. Why invest in global equities? Global markets are inefficient Globalization seems to be making the world less U.S. centric and more balanced through the blurring of national boundaries, especially as it relates to economic activity. This re-balancing is evidenced by a steady decline of U.S. share of global economic output and global equity market capitalization (see Exhibit, below). But, even though both of these metrics suggest a wider range of contributors to global economic output today versus the past, global equity markets have yet to reflect the full extent of the trend toward a less Exhibit : The world is becoming less U.S. centric and more balanced, but global markets are still inefficient, as seen from the U.S. representing less than % of global economic output but still close to % of global equity markets. U.S. share of global gdp and global equity market capitalization U.S. Share of Global GDP (%) U.S. Share of Global Equity Market (%) Period referenced: A.D. to., 8. U.S. Share of Global Equity Market: U.S. share of Morgan Stanley Capital International (MSCI) World Index. *See page for index definition. GDP: Gross domestic product. Source: Angus Maddison, University of Groningen - The World Economy: Historical Statistics, 99 Intn l GK$.** Ramona Persaud Portfolio Manager Naveed Rahman Institutional Portfolio Manager Srinivas Vemparala Quantitative Analyst key takeaways Inefficient global equity markets present ample opportunities for diversified alpha generation. A global equity income approach is a conservative means of capturing this alpha, with lower volatility income prioritized over higher volatility capital appreciation in total returns. Income compounding drives the conservative nature of the approach. A global equity income approach can offer higher dividend yields, breadth in sector and regional income sources, and higher riskadjusted returns relative to U.S. equity income, while also potentially providing traditional equity income characteristics, such as lower than market volatility, risk diversification, inflation protection, and relative downside protection. Effective global equity income approaches focus on companies with competitive advantages that drive aboveaverage returns and reliable cash flow generation, which, when combined with prudent capital allocation, greatly support current and future dividend payments.

2 U.S.-centric world. Specifically, the U.S. now represents less than % of global economic output (compared to a % all-time peak in 9), but U.S. equities still make up close to % of global equity markets. The U.S. being more than double the weight in global equity markets relative to its actual global economic output suggests that global markets are not very efficient, which presents ample opportunities for diversified alpha generation. While it is difficult to time exactly when global equity markets might adequately reflect contributions to global economic output from regions outside of the U.S., it is reasonable to expect the narrowing of this non-u.s. GDP/market capitalization gap (Exhibit ) could be a structural tailwind for non-u.s. equities for some time. Moreover, this tailwind is strengthened by a deep stock-picking universe of almost, liquid stocks outside of the U.S., which compares favorably with only, similarly liquid stocks in the U.S. Company-specific factors play a greater role in returns As globalization creates an increasingly connected world, country contribution to global equity returns has diminished as idiosyncratic company-specific factors become increasingly relevant. This is especially true in emerging markets, which account for a large share of the non-u.s. GDP/market capitalization gap and related investing tailwind mentioned previously. An increased contribution to global equity returns from companyspecific factors means that global diversified alpha has become increasingly derived from stock picking, and therefore increasingly favors investors who connect dots across borders (i.e., global investors) versus those with single country expertise (i.e., local investors). Exhibit : The steady, compounding nature of dividend income makes it a material component of long-term total equity returns. Index value (start 9 =.; log scale) impact of reinvested dividends on cumulative U.S. and U.K. Equity returns,,, U.S.: total return.% per year U.K.: total return.% per year U.S.: capital gain.% per year U.K.: capital gain.% per year Start of Year,9, 98 9 Period referenced: 9-. Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists: Years of Global Investment Returns, Princeton University Press,. This is not an unexpected outcome in today s globalized economy, where the success or failure of a large multinational such as Volkswagen has less to do with its home country of Germany and more to do with its competitive positioning versus its global peers, such as Japan s Toyota, Korea s Hyundai, and the U.S. GM. It should be noted that investing in non-u.s. stocks involves taking some currency risk, since most non-u.s. stocks trade in the local currency of their associated company s home country. A global investment approach (i.e., investing across a wide array of countries), however, can achieve currency diversification, which helps mitigate this risk. Furthermore, many multinational companies have natural currency hedges in the form of local sourcing/ production and selling of goods and services, hence both costs and revenues are in the same currency, which dilutes the impact of any currency mismatches in their global operations. In other words, currency risk is inherent in global investing, but can be mitigated with thoughtful asset selection. Why consider a global equity income approach? Dividend income drives long-term total equity returns due to steady compounding The steady, compounding nature of dividend income makes it a material component of long-term total equity returns. For instance, during the th century, U.S. equities that included reinvested dividends produced over 8 times the return of a portfolio without reinvested dividends, in nominal terms (see Exhibit, below left). The effect of reinvested dividends was even stronger in the U.K., where Exhibit : The dividend yield of non-u.s. equities has been persistently higher than that of U.S. equities. This gap is even higher when a global equity income subset of global equities is compared with global and U.S. equities. Dividend Yield (%) 9 8 Jan- Dividend Yield Comparisons Global Equity Income Global ex-u.s. Equities U.S. Equities Oct- Jul - Apr- Jan- Oct- Jul - Global Equity Income: Represents an income-oriented subset of MSCI All Country World Index (ACWI). Global ex-u.s. Equities: Refers to MSCI ACWI ex-u.s. Index. U.S. Equities: Refers to MSCI USA Index. *See page for index definitions. Period referenced: Jan., to.,. Source: Fidelity Asset Management (FAM) as of.,. Apr- Jan-8 Oct-8 Jul -9 Apr- Jan- Oct-

3 over the same time period and in nominal terms, total returns (i.e., dividends and capital gains) were over 9 times greater than returns excluding reinvested dividends (i.e., capital gains alone). This effect was even more pronounced in real (i.e., inflation-adjusted) terms. Global equity income captures high dividend yields across markets In the past decade, the dividend yield of non-u.s. equities has been persistently higher than that of U.S. equities. Global equities excluding the U.S. have delivered a dividend yield between %-.% during this time compared with a dividend yield of %-% for U.S. equities. This dividend yield gap is even more pronounced when a global equity income subset 8 of global equities 9 is compared with U.S. equities. This global equity income subset has delivered a dividend yield of %-% in the past decade, better than both U.S. and global equities (see Exhibit, page ). A persistently higher dividend yield of non-u.s. versus U.S. stocks is driven by a wide variety of factors across the world. For instance, shareholders who demand cash returns from their equity investments are found in many parts of Asia in the form of high family ownership, whereas in the U.K. and Chile, this has taken the form of historically high pension fund ownership, and in South Africa, this takes the form of post-apartheid era Black Empowerment Enterprise equity stakes in companies, where the debt used to finance these stakes is serviced by healthy dividend streams. In Brazil, a minimum payout of earnings is set at % by law, and many companies set their own by-laws at a payout level above this, leading to a wide variety of stocks with healthy dividend yields. In Australia and New Zealand, dividends are often not subject to double taxation, which incentivizes high payout ratios. In some countries with a history of hyperinflation (e.g., Brazil, Indonesia, Argentina, Germany), above average dividend yields suggests investors demanded high payouts in order to earn real returns. These are only a handful of examples to illustrate structural, regulatory, economic, and other factors behind the theme of healthy dividend yields globally. It is worth noting that such factors have not been present in the U.S. for some time, leading to U.S. payout ratios at historic lows and cash on U.S. company balance sheets at historic highs. When combined with U.S. profitability also at historic highs, the opportunity set for a global equity income investor seems even greater when equity income trough conditions in the U.S. are considered alongside the already strong dividend yield opportunities present outside of the U.S. Global equity income offers significant breadth Global equities offer an abundant opportunity set for equity income investing. As shown previously, a global equity income subset has provided a greater dividend yield than that of global equities and a far greater dividend yield than that of U.S. equities. This is because global equity income is sourced from virtually all global sectors, whereas U.S. equity income is sourced primarily from just three U.S. sectors utilities, telecommunication services, and consumer staples. This results in favorable comparisons by sector of a global equity income approach versus global and U.S. equities (see Exhibit, below). Global equity income is also more abundant in regions outside of the U.S., driven by the country-specific factors described previously, such as shareholder requirements, laws around payout Exhibit : A global equity income subset of global equities has a higher yield by sector and by region when compared with global and U.S. equities because of the ability to source yield from a wide variety of sectors (left) and regions (right). dividend yield by sector dividend yield by region Dividend Yield (%) Global Equity Income U.S. Equities Dividend Yield (%) Global Equity Income U.S. Equities Discretionary Staples Energy Financials Health Care Industrials Technology Materials Teleco Utilities Total Africa/Mideast Asia/Pacific Ex Japan Europe Japan Latin America North America Total Global Equity Income: Represents an income-oriented subset of MSCI ACWI. : MSCI ACWI. U.S. Equities: MSCI USA Index. *See page for index definitions. Source: FAM as of.,.

4 Exhibit : Risk-adjusted returns over the past decade show that a global equity income approach delivered both a better Sharpe Ratio and dividend yield compared with a variety of standard capitalization-weighted equity indices. Dividend Yield (%) dividend yield and sharpe ratio S&P MSCI World MSCI EAFE HDY MSCI EAFE Global Equity Income MSCI World HDY Exhibit : During the 9s era of high inflation, a global equity income approach produced positive real returns and outperformed bonds, U.S. equities, and global equities. performance during 9s inflation period Income Return (%) Price Return (%) Total Return (%) Sharpe Ratio (Annualized) - Bonds Inflation S&P S&P HDY MSCI World MSCI World HDY Sharpe Ratio: Measures risk-adjusted performance by subtracting the risk-free rate from the rate of return and dividing the result by the standard deviation of returns. Period referenced: -year term ending.,. *See page for index definitions. Source: FAM. ratios, tax policy, historic hyperinflation, etc. This, too, results in favorable comparisons by region of a global equity income approach versus global and U.S. equities (see Exhibit, page ). Less volatile equity exposure A global equity income approach tends to be less correlated with global risk appetite. This is driven by income investing s tendency toward lower volatility stocks, as income-oriented companies tend to have steady and predictable cash flows, which often results in lower stock price volatility. In other words, global equity income investing (much like traditional U.S. equity income investing) may provide risk diversification, as seen by income portfolio betas usually lower than. Attractive risk-adjusted returns Risk-adjusted returns over the past decade show that a global equity income approach delivered both better returns per unit of risk (Sharpe Ratio) as well as a higher dividend yield when compared with a variety of standard capitalization-weighted equity indices (see Exhibit, above left). Said differently, over a decade replete with significant equity market corrections, a global equity income approach proved both conservative and rewarding. Inflation protection A global equity income approach may also offer inflation protection versus other asset classes. This is because companies often can pass through rising input costs, such as raw materials and labor, in the form of higher prices on final products and services. For better-managed companies, this is often an opportunity to drive real Stocks and bonds represented by S&P Index, MSCI World Index, and IA SBBI U.S. Intermediate-Term Government Bond Index, respectively, for the -year period ending., 98. Annualized performance data. *See page for index definitions. Source: Morningstar EnCorr and FAM. pricing power (i.e., price increases above inflation), and therefore real profit growth as price drops straight to the bottom line. Incomeoriented companies thus have the potential to generate inflation-protected growth via dividend payments, which are paid out of profits. An example of this phenomenon was during the 9s era of high inflation, where global and U.S. equity income subsets were unique in producing material positive real total returns of.8% and.8%, respectively. In real terms, global and U.S. equity income outperformed inflation (8.%), bonds (-.%), U.S. stocks (.%), and global stocks (.9%), with global equity income s outperformance being significant. Of note, dividends were a material driver of the real total return experienced by income stocks during this inflationary period (see Exhibit, above right). Identifying effective global equity income approaches Winning global equity income approaches focus on companies with competitive advantages that drive above-average returns and reliable cash flow generation, which, when combined with prudent capital allocation, greatly support current and future dividend payments. A thorough global equity income research process should include traditional analysis focused on fundamentals and valuation metrics, as well as credit analysis that assesses balance sheets and dividend paying capacity of potential investments. An emphasis on future free cash flow generation can help evaluate the safety of current dividends as well as the potential to grow future

5 Exhibit : An effective global equity income approach tends to have better valuations, dividend yields, balance sheets, and profitability when compared with global equities. Characteristics of a Global Equity Income Approach GEI Price to Cash Flow 8.. Price to Earnings, FY.. VALUATION Price to Earnings, FY.. Price/Earnings, Trailing.8. Price/Sales.. Dividend Yield..9 BALANCE SHEET Total Debt / Total Capital Operating Margin ROE Year, Trailing PROFITABILITY ROE Year, Average ROE, FY ROE, FY GEI: Global Equity Income data as of.,. data referenced by MSCI ACWI as of.,. *See page for index definitions. Source: FAM. dividends. Such approaches would tend to lead to stocks with better valuations, dividend yields, balance sheets, and profitability when compared with global equities (see Exhibit, left). Such approaches would also tend to maintain a balance of equities with dividend yield, dividend payout, and dividend growth characteristics. For instance, portfolios that held a combination of high dividend yield and reasonable dividend payout stocks and/ or high dividend yield and high dividend growth stocks produced better cumulative returns relative to global equities and relative to other portfolio combinations of yield, payout, and growth, and with a high degree of consistency for more than a decade (see Exhibit 8, below). Potential for downside protection An effective global equity income approach may also provide relative downside protection. This is shown in downside capture Exhibit 8: An effective global equity income approach tends to balance between dividend yield, dividend payout, and dividend growth. cumulative performance of dividend yield and dividend payout % High DY Low PO % High DY Med PO % High DY High PO 8% Zero DY % Low DY Low PO Low DY High PO % Cumulative Return Relative Return (%) % % high dividend yield/medium payout (relative to ) cumulative performance of dividend yield and dividend growth Cumulative Return % % % % 8% % % % % - 9 High DY Low DG High DY Med DG High DY High DG Zero DY Low DY Low DG high dividend yield/high dividend growth (relative to ) Relative Return (%) Relative performance on lower chart is calculated on rolling monthly basis. DY: Dividend Yield. DG: Dividend Growth. PO: Payout Ratio. : MSCI ACWI. All stocks in MSCI ACWI were sorted into terciles on a monthly basis based on dividend yield, with high dividend yield stocks being those in the top tercile while low dividend yield stocks were those in the bottom tercile. Analogous approaches were taken with respect to DG (Dividend Growth) and PO (Payout Ratio). A total of nine groups of were created by combining the top, medium, and bottom tercile dividend yield stocks with that of top, medium, and bottom tercile payout ratio stocks, respectively. The th group contained stocks that do not pay dividends. All these groups were rebalanced monthly and the forward one-month performance was calculated for each of them. A series of such one-month forward performance numbers were chain linked (compounded) to arrive at the cumulative performance numbers that are shown on the charts. A similar approach was taken for dividend yield and dividend growth combination of stocks. Period referenced: Jan., 99 to.,. *See page for index definitions. Source: FAM.

6 Exhibit 9: An effective global equity income approach can provide relative downside protection in down markets as well as reasonable upside participation in up markets. Global Equity Income (GEI) vs. (GE) Up Down Total GEI GE GEI GE GEI GE Annualized Return (%) No. of Periods Annualized Spread (bps) () 8 Capture Ratio (%) 9 9 U.S. Equity Income (USEI) vs. U.S. Equities (US) Up Down Total USEI US USEI US USEI US Annualized Return (%) - -9 No. of Periods Annualized Spread (bps) () Capture Ratio (%) 9 Performance is calculated on a rolling monthly basis. Up capture is calculated for periods of positive index performance, whereas down capture is calculated for periods of negative index performance. Annualized performance is calculated over the entire period (June, through., ). Global Equity Income: Represents an income-oriented subset of MSCI ACWI. : MSCI ACWI. U.S. Equity Income: Represents an income-oriented subset of MSCI USA Index. U.S. Equities: MSCI USA Index. *See page for index definitions. Source: FAM. Tax considerations Investing in non-u.s. dividend-paying equities can have different tax implications versus investing in U.S. dividendpaying equities, depending on an investor s tax status. Taxable investors should generally be indifferent, on an after-tax basis, between investing in non-u.s. or U.S. dividendpaying equities due to foreign tax credits available to U.S. investors. Tax-deferred investors, however, will generally incur a marginally higher tax cost when investing in non-u.s. dividend-paying equities in many foreign countries as a result of dividend withholding taxes imposed by the foreign country, but this cost is often offset by the greater yield provided by foreign dividends. Taxable investors should also be aware that the favorable rates applicable to qualified dividends are due to expire in ember. Because tax considerations can be investor-specific and subject to policy change, please consult a tax advisor for more details. ratios below % for equity income approaches in both global and U.S. markets (i.e., income investors have experienced less downside than their respective broader markets) see Exhibit 9, above. An added benefit of a global equity income approach, however, is that it has also shown attractive upside capture historically, a result of its participation in a wide array of sectors and regions globally. In other words, a global equity income approach adds value more from alpha than beta sources. Investment implications A global equity income approach may address the needs of conservative equity investors seeking lower volatility, higher risk-adjusted returns, risk diversification, inflation protection, downside protection, as well as may provide better and more wide-sourced income generation from dividends in an era of historically low U.S. fixed income yields. Authors Ramona Persaud Portfolio Manager Ramona Persaud is a portfolio manager for Fidelity Asset Management. She is a co-portfolio manager of the global equity income subportfolio of Fidelity Equity- Income Fund, which she began co-managing in October. Naveed Rahman Institutional Portfolio Manager Naveed Rahman is an institutional portfolio manager for Fidelity Asset Management. He assumed his current position in the equity division in ember, and is responsible for representing value and equity income strategies to institutional clients, prospects, and consultants. Srinivas Vemparala Quantitative Analyst Srinivas Vemparala is a senior quantitative research analyst for Fidelity Asset Management. He currently is part of the Equity Quantitative Research division and is a member of the global equity income research team. He is involved in risk model and portfolio construction research.

7 Endnotes The large dip in the 98s of U.S. share of global equity market capitalization is a result of the Japan asset bubble during that period. U.S. share of global equity market capitalization recovered in the 99s, but not back to its prior peak. Global equity market capitalization refers to MSCI World Index, a free-float-adjusted, market-capitalization-weighted index designed to measure the equity market performance of developed markets. Global economic output or GDP (gross domestic product), refers to the market value of all officially recognized final goods and services produced in developed and emerging countries around the world. MSCI as of Jan.,. Fidelity Asset Management Anova methodology on MSCI World total returns, Idiosyncratic risk: risk associated with unique circumstances related to a specific asset, as opposed to the broader market. Alpha: the excess return over a benchmark, taking into account the risk taken to obtain that return. Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists: Years of Global Investment Returns, Princeton University Press,, Chapter. Proxied by MSCI s All Country World Index ex-u.s. Proxied by MSCI USA Index. 8 Global equity income represents a subset of MSCI All Country World Index containing securities with greater than average dividend yields and reasonable dividend per share growth and dividend payouts. This is consistent with a number of public indices, including MSCI USA High Dividend Yield Index and MSCI World High Dividend Yield Index. 9 Proxied by MSCI All Country World Index. Hyperinflation: inflation that is very rapid or out of control. Trough conditions: The minimum point of a complete cycle of a periodic function, such as the low point in a time series of performance for an asset. Portfolio beta: A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. A beta of indicates that the security s price will move with the market. A beta of less than means that the security s price will be less volatile than the market. A beta of greater than indicates that the security s price will be more volatile than the market. See Exhibit 9 for reference data. MSCI All Country World Index did not yet exist. MSCI World is its predecessor and contained the largest economies during the time period analyzed, out of which an equity income subset was derived, consistent with MSCI s methodology of HDY indices. Similarly, MSCI USA Index did not yet exist, so S&P Index is used as a proxy for U.S. equities, out of which an equity income subset was derived, consistent with MSCI s methodology of HDY indices. Real global equity income total return:.% (nominal) - 8.% (inflation) =.8% (real). Real U.S. equity income total return: 9.8% (nominal) - 8.% (inflation) =.8% (real). Downside capture ratio is analogous to a portfolio s beta during down markets; a downside capture ratio less than % is ideal. Upside capture ratio is analogous to a portfolio s beta during up markets; an upside capture ratio greater than % is ideal. *Global Equity Income: an income-oriented subset of Morgan Stanley Capital International (MSCI) All Country World Index containing securities with greater than average dividend yields and reasonable dividend per share growth and dividend payouts. This is consistent with a number of public indices, including MSCI USA HDY Index and MSCI World HDY Index. **GK$: Geary-Khamis dollar, more commonly known as the international dollar, is a hypothetical unit of currency that has the same purchasing power that the U.S. dollar had in the United States at a given point in time. MSCI All Country World Index: a free-float-adjusted, market-capitalization-weighted index designed to measure the equity market performance of developed and emerging markets. MSCI All Country World (ACWI) ex-u.s. Index: a free-float-adjusted, market-capitalization-weighted index designed to measure the equity market performance of developed and emerging markets outside of the United States. MSCI USA Index: a free-float-adjusted, market-capitalization-weighted index designed to measure the equity market performance of the United States. U.S. Equity Income (MSCI USA HDY): an income-oriented subset of MSCI USA Index containing securities with greater than average dividend yields and reasonable dividend per share growth and dividend payouts. MSCI World Index: a free-float-adjusted, market-capitalization-weighted index designed to measure the equity market performance of developed markets. MSCI World HDY: an income-oriented subset of MSCI World Index containing securities with greater than average dividend yields and reasonable dividend per share growth and dividend payouts. S&P Index: a market-capitalization-weighted index of common stocks, is a registered service mark of the McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation. MSCI Europe, Australasia, Far East Index (EAFE): a free-float-adjusted, market-capitalization-weighted index designed to measure the equity market performance of developed markets outside of the United States and Canada. MSCI EAFE HDY: an income-oriented subset of the MSCI EAFE Index containing securities with greater than average dividend yields and reasonable dividend per share growth and dividend payouts. Ibbotson Associates (IA) SBBI U.S. Intermediate-Term Government Bond Index: a one-bond portfolio that is the shortest non-callable bond with a maturity between five and six years, and it is held for the calendar year. U.S. government-issued Treasury bonds were chosen because they experienced no defaults and were generally presumed to offer little credit risk, which provides a focused illustration of the impact of interest rate movements. MSCI s methodology of HDY indices: each MSCI High Dividend Yield Index is composed of those securities in the parent index that have higher-than-average dividend yield, a track record of consistent dividend payments, and the capacity to sustain future dividend payments. Other Important Information It is not possible to invest directly in an index. All indices are unmanaged. Before investing, consider the funds investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully. Past performance is no guarantee of future results. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments. Fidelity does not assume any duty to update any of the information. Foreign securities are subject to interest-rate, currency-exchange-rate, economic, and political risks, all of which may be magnified in emerging markets. These risks are particularly significant for funds that focus on a single country or region. Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Investment decisions should be based on an individual s own goals, time horizon, and tolerance for risk.

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