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Dividend policy

Nick Purves and Ian Lance left Schroders for RWC Partners in May 2010 after building a strong track record and following on a £1bn-plus income franchise.

At their new home, the pair launched income opportunities and enhanced income funds on arrival, with the latter using a covered call strategy to boost yield.

Ex-head of global equity research at Gartmore, Lance presents a compelling case for an income strategy, with two-thirds of total returns in the long run coming from dividends.

Several studies over the years have highlighted the benefits of income and Lance flags up analysis by London Business School professors Dimson, Marsh and Staunton.

This compared compound returns from £1 invested in the highest-yielding half of the UK market since 1900 with the same amount in the lowest half.

A pound produced slightly over £4,000 in the low-yield strategy, around £20,000 from just investing in the market and more than £92,000 in the higher-yielding stocks.

Lance says: “Dividend strategies also tend to be more defensive and less volatile due to the yield cushion, which means it could prove a good approach for the next few years. There are basically three elements of equity returns, dividend yield, growth in real income and change in valuation. Our view is that equity markets remain fully valued so any substantial re-rating is unlikely and dividends should produce their traditional high share of total returns.”

Lance says this is very different from the 1980-2000 period, where a broad bull market inflated P/E ratios and diminished the contribution of dividends.

After 20 years of upward re-rating, the US market got to a highly overvalued level of around 50 times and much of the 2000-2010 period consisted of de-rating and dividends rising in importance once again.

Lance says: “Massive de-rating of these high-quality blue chips has created a major opportunity to buy the world’s strongest companies at discount levels.”

Johnson & Johnson, for example, has grown its earnings and dividend every year for the last decade but its share price has gone nowhere.

Lance says: “Back in 2000, the company was much too expensive at 30 times earnings and the same was true across sectors like telecoms and healthcare. Most of the last decade has been about de-rating these shares back to appropriate levels but we feel it has now gone too far the other way and many are now cheap. They are also better companies than a decade ago less concerned with expensive acquisitions and more attuned to paying dividends and buying back shares.”

Lance and Purves have around a quarter of their portfolio in pharmaceuticals, with a further 15 per cent in telecoms. Several of these currently have free cashflow yields of between 10 per cent and 15 per cent, which provides scope for dividend growth.

While not expecting a major re-rating of equities as in the 80 and 90s bull market, Lance says there is potential in too-cheap healthcare and telecom stocks. This could create a similar return profile to tobacco in the 2000s, with the sector re-rating from an extremely unpopular position.

“A stock such as British American Tobacco has produced annualised returns of 20 per cent-plus over the last 20 years despite volumes in the sector actually falling annually.

“The company has taken costs out and kept operating profits high, consistently using free cashflow to buy back shares and increase its payout ratio.”

Looking at a stock such as AstraZeneca, the company lagged last year as the sector outperformed based on concerns over patent expirations for drugs such as Crestor.

Lance says: “Even taking some of the most bearish forecasts for cashflow after these patent expiries, the shares are on a 12 per cent free cashflow yield and have a dividend yield of 6.1 per cent as well as net cash on the balance sheet.

If the free cashflow yield re-rates to a market average of 8 per cent, the stock will be producing annualised returns above 20 per cent.

Looking across the market, Lance highlights similarly undervalued stocks across several sectors. With Royal Sun Alliance, for example, he says insurers tend to trade like proxies for the banks and its shares therefore fell from 140p last July to below 100p by mid-December.

“The reality is that the business models are very different, meaning earnings are less volatile and balance sheets healthier,” he says.

After the fall, the shares offer a yield of over 9 per cent on a dividend more than 1.5 times covered.



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