• Dividend investing is not merely an income diversifier, it is also a source of growth that has the potential to keep up with inflation.
• Against a backdrop of increased volatility, the Vanguard Global Equity Income Fund has continued to focus on companies with the ability and willingness to pay dividends, regardless of the market environment.
  
• Our view is that dividends can provide an income stream, which, together with the upside potential of price appreciation, can offer a valuable diversification benefit to investors.
  

 

Dividends may not have featured too highly on investors’ radars in recent years when share price appreciation, driven by high-growth technology stocks, dominated the headlines. 

Over the course of the past year, however, investors’ interest in value investing rose as economic growth waned, geopolitical tensions grew and central banks raised interest rates sharply to reduce persistently high inflation. 

Since then, equity income funds, which tend to be more value-oriented, have come back into focus. Rising interest rates have meant that companies with stable cash flows and resilient earnings have been, in general, less impacted by the rising cost of capital. These qualities can be a defensive characteristic in the face of elevated market volatility.  

Against this backdrop, the Vanguard Global Equity Income Fund has continued to focus on companies with the ability and willingness to pay dividends, regardless of the market environment. 

The fund is managed by two investment firms. Wellington Management seeks to find the best dividend-paying companies with strong balance sheets and competitive positions, while Vanguard’s Quantitative Equity Group (QEG) aims to identify the best dividend payers across a variety of sectors and geographies.

Dividends as a source of growth  

Dividends reflect the portion of a company’s profits that their management chooses to distribute to shareholders and can provide a regular income stream for equity investors. In normal market environments, while capital gains are influenced by market direction, dividends are usually paid whether the broad market goes up or down. 

During equity market downturns¹, dividends – even if they are reduced by some companies – are typically reinvested and compounded over the long term. That income stream, together with the upside potential of price appreciation, provides a valuable diversification benefit to investors.

Dividend investing, however, is not merely an income diversifier, it is also a source of growth that has the potential to keep up with inflation. 

For Wellington, investing in businesses with prudent dividend policies offers the potential for both attractive current income and compelling long-term total returns. This means that disciplined management teams will take advantage of opportunities that they believe will deliver attractive returns by reinvesting their profits to maintain and grow their businesses before distributing the remainder of their profits as dividends.

Portfolio manager Andre Desautels, who manages the Wellington portion of the Vanguard Global Equity Income Fund, leverages Wellington’s broad network of investors, including the firm’s global industry analysts, to identify asymmetrical risk/reward opportunities—stocks considered to have limited downside risk, good upside potential over time and sustainable dividends. 

For example, going into 2022, Andre identified US pharmaceutical firm Merck as a good example of a stock offering asymmetry in risk and reward. The stock was up strongly last year in a falling market. It became clear that there was greater appreciation from shareholders for the business, the successes of its drug development pipeline and its pharmaceuticals business in general. 

When Andre bought a position in Merck at a valuation which he believed was compelling for a high yielding company, its animal health business and vaccines franchise represented about one-quarter of the business in 2022, but he sees these franchises growing over the next 10 years. 

Dividend coverage and sustainable dividend growth

While Wellington focuses primarily on the long-term fundamentals of large-cap, quality² companies which are temporarily out of favour, Vanguard QEG is driven by purely quantitative analysis and financial modelling with a focus on stock characteristics. 

Like many traditional managers, Vanguard QEG selects stocks using fundamental, bottom-up criteria. The difference between Vanguard QEG and Wellington, however, is that Vanguard QEG applies its process quantitatively, which allows the team to execute at scale. 

For Vanguard QEG, companies with high and sustainable dividend growth tend to be financially sound and profitable, making them more defensive against high inflation risk and more immune to interest rate risk. It has been found that portfolios with exposure to stocks with better dividend coverage³ can also benefit, particularly during periods of high inflation (see Figure 1). 

Figure 1: Relative performance of stocks by dividend coverage and inflation range

	Average Inflation	High coverage	Middle	Low coverage
Full period	2.4%	4.2%	-0.3%	-3.9%
Low inflation	1.3%	3.7%	0.8%	-4.4%
Middle	2.5%	4.4%	-1.3%	-3.1%
High inflation	4.0%	4.5%	-0.1%	-4.4%

Source: Federal Reserve Bank of St. Louis, Bloomberg, Vanguard QEG Research. Performance reflects equal-weighted average of stocks in the group relative to the equal-weighted average of the set of stocks included in the analysis (all S&P 500 dividend-payers). Returns are in USD, gross of fees, with income reinvested. Monthly data from 31 December 1990 through to 31 December 2021. 

Past performance is not a reliable indicator of future results.

All things being equal, higher coverage ratios (or lower payout ratios) mean more earnings are available to either pay higher dividends to shareholders or to grow future earnings through reinvestment, both of which make future dividend growth more sustainable.

This feature is a key component of Vanguard QEG’s new equity income model. The model systematically ranks dividend-paying stocks by their level of attractiveness based on fundamental factors. This means that a stock with higher expected dividend per share (DPS) growth and higher expected dividend coverage will be viewed as more attractive. The model combines this with other proprietary factors and is used to construct a portfolio of dividend-paying stocks with the propensity to outperform in a variety of market conditions.

At Vanguard, the philosophy around global equity income investing is anchored in the belief that dividends are a meaningful part of market returns and that stocks with strong, sustainable yields can outpace inflation to help provide consistent risk-adjusted returns over the long term. 

 

¹ In a worst-case scenario companies may stop the dividend payment entirely. Dividend cuts can happen for a variety of reasons. On some occasions, a company may see an opportunity to reinvest in its business – perhaps via an acquisition - rather than pay the dividend. More often, it is due to declining profits. Companies may be able to maintain their dividends for a while, but if profits continue to decline then eventually their capacity to pay those dividends will be constrained. 

² Seeking well-managed businesses within durable industry structures trading at attractive free cash flow-based valuations. The highest yielding stocks are often cheap for a reason: maximising dividend yield increases portfolio risk to a greater degree than it improves portfolio returns. 

³ The dividend coverage ratio measures the number of times that a company can pay dividends to its shareholders, i.e. well covered by earnings.