June 2008

For professional investors or advisers only

Schroders The case for yield investing

By Sonja Schemmann, Global and European equity fund manager, Schroders

The power of investing for dividends

Despite a difficult time for yield strategies in the second half of 2007, value is now emerging in dividend paying stocks. Moreover, the structural case for long term yield investing has never been stronger. Investors are increasingly wearing the burden of saving for retirement and need to invest in secure, growing income streams. Carefully selected dividend paying stocks help address this burden: real dividend growth is a major component of long-term stock returns and when reinvested is a significant contributor to long term total return. Dividends are more stable than earnings, providing downside capital protection. Dividend payout instils capital discipline in management teams and high yield stocks have been shown to signal subsequent years earnings growth. Emerging value The second half of 2007 was a difficult time for yield strategies. With commodity prices rising and the spillover of the US sub-prime crisis into global credit markets, market performance diverged dramatically. Low yield mining and energy companies exposed to commodity prices and the structural growth story of emerging markets performed well. Financials, consumer related and manufacturing stocks suffered; punished by investors concerned about the impact of the US slowdown on Europe. Moreover, momentum outperformed all other investment styles in 2007, demonstrating the shortterm focus of investment markets over that time. Momentum outperformed all other strategies in 2007

Source: James Montier, Societie Generale

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Selective financial stocks now look to be good value. UK bank yields (and their European counterparts) are trading above 10 year government bond yields and across the sector there are high quality companies that have largely avoided the worst elements of the credit crisis. UK Bank yields vs UK 10 yr government bond yield
8 7 6 5 4 3 2 99 00 01 02 03 04 05 07 08

UK-DS Banks - DIVIDEND YIELD

UK BENCHMARK 10 YEAR DS GOVT. INDEX - RED. YIELD

Source: Schroders, Datastream

Outside financials, European corporate fundamentals are reasonably strong. Despite short-term worries on the economic outlook, balance sheets are in good shape and in many cases dividends are still well covered. Well run, stable growth companies still have the ability to pay dividends and reinvest for growth. In volatile markets, companies with strong fundamentals such as regular dividend payments and strong balance sheets provide downside protection to share prices. Companies that show discipline and use their cash to both pay dividends and reinvest for growth should provide capital protection on the downside and secure future growth in earnings and dividends.

Dividend yield %
USA Europe ex. UK UK Japan Asia ex. Japan Canada GEM World 2.3 4.1 3.7 2.0 4.5 2.3 2.9 3.0

Dividend growth % p.a.*

5.0 9.9 4.7 8.9 6.6 2.0 16.1 7.8

Dividend cover %*
3.23 2.22 2.33 4.00 1.75 3.33 2.86 2.70

Payout ratio
31 45 43 25 57 30 35 37

Source: UBS to end Dec 2008 *Dividend growth in % YoY, Dividend cover based on earnings

Structural case for yield investing The first American baby-boomer filed for early retirement in October 2007. With a bulge of retirees filing for pensions over the next 10 years, there has never been a better time to look at the structural case for equity yield investing. Globally, the burden of saving for and investing in inflation beating income streams for retirement is shifting from governments to individuals. Over the last two decades, yields on traditional savings and income investments such as bonds have fallen significantly. Despite falling property values, rental yields still do not provide the same opportunities as selected dividend paying equities. Furthermore, with rising inflation, real interest rates are approaching zero and it is important to ensure investors have an asset base that will generate rising real income over the long term.
2

June 2008

For professional investors or advisers only

US & UK Interest rate trends vs Inflation Rate

16 14 12 10 8 6 4 2 0 88 89 91 93 95 97 99 01 03 05 07
2 0 88 90 92 94 96 98 00 02 04 06 08 8 6 4 12 10

US federal funds target rate (EP) UK Bank of England base rate (EP)

US CPI-all urban sample: All items - annual inflation rate NADJ UK RPI-inflation rate

Source: Schroders, Datastream

One solution to this structural problem is to invest in a carefully chosen, diversified portfolio of dividend paying companies. In addition to an attractive initial dividend yield, these companies should have competitive business models, strong balance sheets and the potential for superior earnings growth. Over time, a portfolio of these types of companies should provide capital and real income growth thus helping to solve the structural dilemma investors currently face. Dividends crucial to long-term returns From a long-term perspective, investors should always consider exposure to income securities. Over the last 200 years of US market history, dividends and growth in dividends have provided 5.8% of the 7.9% per annum stock return. The chart below demonstrates how dividend yield and growth in dividends has been the major contributor to equity returns in the US since 1871. 128 year decomposition of equity returns
20 15 10 5 0 -5 -10 1871-2007 DY 1990-2000 Growth in real dividends 2000-2007 Change in valuation

Source: James Montier, Societe Generale

Long-term portfolio returns are also driven by reinvestment of income. Whilst the rule of compound returns is well known, the graph below demonstrates the sheer power of reinvesting dividend streams. A portfolio invested in the MSCI in 1970 with dividends reinvested would have returned

June 2008

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9.8% per annum by March 2008. In contrast, a portfolio invested at the same time but with no dividends reinvested would have returned 6.3% pa by March 2008.
4000 3500 3000 2500 2000 1500 1000 500 0 1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1995

1997

1999

2001

2003

2005

2007

MSCI WORLD - PRICE INDEX

MSCI WORLD - TOT RETURN IND

Source: Schroders, Datastream

Dividend streams are also more stable than earnings. While earnings of the MSCI have shown significant volatility since 1970, dividends have been steadily rising. In addition to this characteristic, payout ratios have steadily fallen. This indicates that the chance of dividend payments falling in coming years is low and in fact demonstrates that companies have the ability to continue to grow their dividends.
1,800 1,600 1,400 1,200 1,000 50% 800 600 400 200 0 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1995 1997 1999 2001 2003 2005 2007 45% 40% 35% 30% 70% 65% 60% 55%

MSCI Dividends

MSCI Earnings

Payout (rhs)

Source: Schroders, Datastream

Capital discipline Regular dividend payout instills a sense of capital discipline in company management teams and is a sign of earnings quality. A dividend paying management culture will be more careful when assessing the relative merits of risky acquisitions and investments as they have concrete cash returns to shareholders to weigh their investment decisions against. Furthermore, when availability of capital is limited, management will adopt a disciplined approach to finding the best reinvestment options that grow both earnings and dividends. There is a common myth that high yield companies are ex-growth and should be avoided. To the contrary, the chart on the next page a study by Arnott and Asness looking at US stock data from 1946 to 2001- demonstrates that high yield companies on average show better subsequent earnings

June 2008

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growth over 10 years than low yield companies. This simply reinforces the notion that a disciplined dividend payout culture will eventually yield long term superior returns to shareholders. Dividend = Earnings growth
Starting Payout Quartile
4 (Low)

Average subsequent 10yr earnings growth (%)

0.4

Worst subsequent 10yr earnings growth (%)

-3.4

Best subsequent 10yr earnings growth (%)

3.2

1.3

-2.4

5.7

2.7

-1.1

6.6

1 (High)

4.2

0.6

11.0

Source: Surprise! High Dividends = Earnings Growth, Arnott & Asness, Financial Analysts Journal Vol.59, no 1, January/February 2003. Data quoted from 1946 to 2001, US market.

Diversified approach Despite the short term impact over 2007, the risk profile and hence volatility of dividend funds is lower than comparable benchmarks, while the average turnover of high-yielding stocks is only half that of non-dividend paying stocks. As a result of this lower risk profile and lower volatility, yield investments help improve the overall risk/return profile of the equity proportion of any portfolio and are an ideal complement to higher risk assets such as Asian or emerging market equities. The best way to gain low risk exposure to high-yielding stocks in Europe and globally is through a diversified managed fund. Investing directly in individual securities carries much higher risks and costs than investing in an equity yield fund. A typical equity yield fund may contain on average 60 stocks, all of which have been selected by a specialist fund manager and, in most cases, a team of analysts with in-depth knowledge of industries and sectors the benefits of diversification are clear. Even the most sophisticated private investor will find it hard to generate better returns at lower risk through direct investment in individual securities. A professionally-managed fund is also more likely to find opportunities beyond traditionally highyielding sectors like utilities and financials. A refocusing on shareholder returns over the last few years has prompted companies across all sectors of the European equity market to re-think their use of cash. It is now possible to gain exposure to high yielding stocks from a range of industries to ensure broad diversification within a fund. Europe and certain emerging markets have, in particular, seen a lot of dividend increases and initiations. Managed funds can also offer more sophisticated dividend strategy approaches. We favour an approach that combines growth and yield, looking for exposure to attractive business models and superior earnings growth, at the same time as a regular income stream. Dividend strategies are still in the developing stage in Europe and we believe that they are not in danger of turning into a bubble. Despite a difficult second half in 2007, the strategy is still attractive a stockpicking approach to investing with a dividend strategy should continue to produce good longterm returns in most market conditions.

June 2008

For professional investors or advisers only

June 2008 Important Information:

The views and opinions contained herein are those of Sonja Schemmann, Global and European Equity Portfolio Manager, and do not necessarily represent Schroder Investment Management Limiteds house view. For professional investors and advisors only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored.