Presenter: Joining me today is David Hogarty, Head of Strategy Development for Dividend Plus, and Geoff Blake, Director and Head of Business Development at Kleinwort Benson Investors. So I wanted to begin by having you tell us a little bit about who Kleinwort Benson Investors are.
Geoff: Kleinwort Benson Investors was founded in 1980. We have a long tradition of investing in long only global equities. We're headquartered in Dublin, but we have operations in New York and London. We have about 300 clients in Europe, the UK, US, Canada and Asia, in total we have about 58 employees, and mainly we invest money on behalf of institutional investors and some global subadvisory relationships as well. The fact that we have a long tradition of meeting our clients' needs, from a service, product and performance point of view, is the reason we have such a long tradition and successful tradition in the business.
Presenter: What type of asset manager are you?
Geoff: We're a boutique asset management firm. We're built around a number of specialist investment teams, and this is a very deliberate strategy from our point of view to build out our business, because we believe having these specialist teams who work independently and focus on the investment universe, purely from their products' point of view, is the best way to add value for our customers. Each of our strategies has its own robust and definable investment process and portfolio construction method, and all of the strategies are built around a number of investment themes that we will think will drive investment returns for the next number of decades.
Presenter: I understand there are three strategies, can you explain those?
Geoff: The first strategy is called our Dividend Plus Equity Strategy, and it's built around the twin themes of population, ageing population and slower economic growth. In terms of ageing population, this will lead to a higher demand for income and income orientated products, and in terms of slower economic growth, this will lead to more muted returns, and we believe in this environment investors will begin again to focus on the income element and what significant part of total return that that makes. The second set of strategies are environment strategies, which is built around the three themes of rising population, demand/supply imbalance for commodities and climate change. And finally our multi-asset strategies which are marketed mainly in the Irish market, which combine some of the best ideas from the first two products, as well as a number of external providers, of best in class products to provide a one stop solution for our pension fund clients.
Presenter: So what is the attraction of investing in companies that make strong dividend commitments to their shareholders?
David: We believe that companies that pay high dividends are very appropriate companies for institutional investors. If you think of the way high dividend companies tend to behave, they do very very well when markets are bullish, which is typically when people look for alpha most from their fund managers. Equities as an asset class are a total return asset class, so it's the combination of both the capital appreciation that they deliver and the income delivery over time. Typically investors are very very focused on the first part of this equation, which is the capital appreciation, but they give far less attention to the second part of the equation which is the income delivery. Over time, when you look at equity returns, it's actually the reinvested income component that dominates the total return and not actually the short term capital appreciation.
So this is a very interesting space for us to look at. If we look at the second side of the equation, capital appreciation, one of the things that is not understood very well by investors is the ability of companies that make dividend payments or high dividend payments to also deliver profits which are in excess of the expectations that investors have. Because they deliver profits at a great rate than the expectations investors have priced in, that generates positive surprises on the profit side, which pushes the share price forward. This is a very important dynamic as a fund manager when you're trying to outperform indices and outperform your competitors.
Aside from low investor expectations, there are a number of reasons why high dividend payers can grow their profits at a supernormal rate. One of the reasons for this is the way in which they manage their capital. Again, one of the things that investors don't do is look at what do companies do with their profits after they generate them. So investors tend to look at how companies deliver profits but not what they do with them once the profits are made. This is where we spend a lot of time, and it's one of the things that we think makes us different to other types of investment managers. Typically companies that make high dividend payments don't have a high level of retained earnings; in other words they don't keep the cash on their balance sheet and do nothing with it. They either tend to put it to work or they pay it out to their shareholders in the form of dividends. The other things that high dividend payers tend to do is be very efficient with the investment projects that they undertake, so while they may undertake fewer projects or spend less money on reinvestment, they tend to be more effective with the investments that they do undertake.
The last point in relation to profits is the quality of the profits that they deliver. Typically we believe that companies that make high dividend payments to their shareholders have higher governance standards and their accounts tend to be a more realistic reflection of the actual underlying economic activity within a business. Typically high dividend payers have a lower level of accruals than the broader market would do, which means that their earnings are a lot more realistic and a lot more sustainable over time.
Presenter: So is now a good time to invest in this kind of strategy?
David: We believe that now is an excellent time to invest in this type of strategy. Firstly, we'd encourage our investors to think long term and not to be very very focused on the short term outlook; however, we do believe that the current events in markets make it particularly attractive to look at high dividend payers. As we've mentioned in an earlier part of this interview, our view is very much that economic growth in the developed world will be quite muted moved forward. This has two implications for investors. One it increases the value of the role that income can make to your developed world equity portfolio. It also creates a compulsion to invest in emerging markets.
One of the reasons that we think investment returns will be muted and income will play a higher role is that government support which has driven equity markets forward in the last few years will begin to dry up in the second half of this year, and a lot of the quantitative easing and fiscal support that we've seen will mean that companies will need to stand on their own two feet again. Typically that means you need to be investing in companies that are strong, have healthy balance sheets and lots of cash flow, high quality companies. Typically companies that make big dividend payments to their clients are such high quality companies. So we think the world will move away from a rally in low quality stocks to a rally in undervalued high quality stocks.
The last reason why we think high dividend payers will do well in the developed world is that companies are very cash rich at the moment. The amount of cash they have on balance sheets is at historic highs, while the amount of return that they're paying out to their shareholders in the form of dividends is at an all-time low. That's a situation that shareholders won't stand for too much longer. Companies don't need to sacrifice other forms of capital investment in order to increase their dividend payments, because the levels of cash are so excessive that they can afford to increase their dividend payments, buy back shares and destroy them, and also pursue M&A activity, so we expect to see an increase on all of those levels.
I make a final word about the timing in relation to emerging markets because it may not be intuitive to people that a dividend based approach or an income orientated approach, which is quite low risk, can do well in a high growth environment like emerging markets. Again, this comes back to people's expectations and the fact that people don't process the information correctly about high dividend payers. Our method works fantastically well in emerging markets, in fact we get significantly better results there than we do in our developed world portfolio, and this is primarily back to the type of secular arguments we talked about at the start of the presentation. Those inefficiencies are much greater in emerging markets because people tend to jump in for growth but forget about all the other things that are important, like valuations and quality and good information.
There is a particular issue in relation to information from companies in emerging markets, it's much poorer and dividends are a way of ensuring that the information you receive from companies is more accurate, which makes us more confident as a fund manager that the investments that we make will be profitable.
Presenter: What are the main risks with an approach like this? Are there particular problems that need to be considered?
David: Absolutely, it's a very interesting question. One of the things we noticed when we started working on the strategy eight or nine years ago was that while we liked the idea of lots of dividends, the traditional way of managing dividend based portfolios wasn't appropriate anymore in a global environment and in an increasingly globalised environment. In particular, there are problems with industry concentration and regional concentration that need to be dealt with from a portfolio construction perspective. If you just screen companies based on their dividends in an absolute way, you'll end up with very extreme concentrations in very few industries and not a properly diversified portfolio; you've got a relatively limited opportunity set as opposed to a very broad opportunity set, and we like much broader opportunity sets.
So we work within a framework that's primarily industry group neutral and regionally neutral, this allows us to bring a lot more diversity to our portfolios than other dividend based managers can typically deliver. There's also quite an irony with this, which is that people expect high dividend portfolios to be less risk than other types of strategies. However, unless you correct for the industry concentration you're going to end up with portfolios that are far more volatile than the broad market, and we can see this when we look at traditional high dividend indices and compare them to broad market returns.
A few other things that you need to check for is that similar to having an industry group and a regional spread you need a good market capitalisation spread. Traditional dividend approaches are very overweight in large-cap stocks, but they don't give you good exposure to small and mid-cap stocks. And we like having overweight positions in small and mid-cap stocks because they tend to outperform over time. One of the ways that we do that is we emphasise dividend growth in our portfolio because over time the best combination for investors is above average yields combined with high dividend growth rates. Yields on their own time not to be enough, and yields on their own can lead you to issues in relation to poor quality or devalued biases, and we don't want investors to be exposed to those types of companies. So, typically, we look for high dividend growth rates which over time deliver very good excess return in combined with high dividend yields.
Presenter: Dividends have always been the life blood of equity returns, but are they still relevant in the modern financial world or do you believe they need to be updated in any way?
David: It's a very good question. We do prefer dividends, but we do also believe that it needs to be updated a little bit. So what I mean by that is that there are many ways that companies can return value to their shareholders. Dividends is one very important way and the most obvious way, but they can also destroy their shares, reduce the number of shares that they have in issuance, which in the States they tend to call buybacks, we tend to focus more on share destruction because we want to see the number of shares actually taken out of circulation rather than just bought back. So it's not a pedantic point, it's actually a very important issue for investors. And the last part of the equation is rights issues.
So if you think of pay-out in a total way or a complete way, there's two positives and one negative; dividends are a positive, share destruction is a positive and rights issues are a negative. So what we try and do is net all those out to get a figure that represents the total cash exchange between a company and the shareholders that are invested in it. We think this is more appropriate in the modern world because share destruction has become a lot more prolific in recent decades, particularly in the US. So it's about how a company manages its capital and how it shares its capital with the people who own the business, which is the shareholders, rather than just the dividend payments.
Presenter: David Hogarty, Geoff Blake, thank you.
David: Thank you very much.
Geoff: Thank you.
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