Why now for US equity income?

Key takeaways:

• Although US equities have performed well so far in 2023, there has been a narrow leadership from the so-called “Magnificent Seven” companies (Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia and Tesla).
• In addition to strong participation in up markets, our strategy focuses on risk mitigation in uncertain markets, preferring stocks of companies that can withstand economic fluctuations.
• We do not aim to solely maximize upfront yield but focus on a balance of current yield and growth of yield. In an inflationary environment, income growth is crucial for protecting purchasing power.

Resilient US economy with narrow leadership in equities

Throughout 2023, investors expected that the United States would be in a recession and the US Federal Reserve (Fed) would begin to cut interest rates in the back half of the year. Yet, not only did the Fed not cut rates, it also raised them. Third-quarter 2023 economic growth was the strongest on record. Thus, macroeconomic conditions have evolved and remain fluid.

US equities, as measured by the S&P 500 Index, have performed strongly so far in 2023. However, there has been a narrow leadership by the so-called Magnificent Seven stocks: Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia and Tesla.

As of September 30, 2023, the Magnificent Seven represented around 25% of the market capitalization of the S&P 500.¹ Only two out of these seven, Apple and Microsoft, pay dividends.²

In our analysis, there will likely be a mild US recession in 2024 and the Fed will keep rates elevated for a longer period of time than the market expects. We also believe that US equity valuations are still too high and will likely decline as the Fed continues to battle inflation.

Risk mitigation in uncertain markets

We do not concentrate on macroeconomic data, however, and instead design our portfolio to do well in different environments, which can include unanticipated inflation, deflation, economic growth, recession, and high and low interest rates. We prefer stocks of companies we believe can ride out economic storms.

Among other things, our strategy aims to provide risk mitigation in bearish and more volatile markets. Our approach is to invest in companies with strong balance sheets, low levels of leverage, durable revenue streams, high returns on invested capital and wide competitive moats that we believe can weather challenging market conditions. 

While periods of rising markets lift returns for all assets, the underlying conservatism of our strategy means it will tend to lag in very hot markets like the one we have seen in 2023.

On the flip side, the deeper the correction in equity markets, the more risk mitigation we believe we can offer. In short, our strategy is not as growth-oriented as the S&P 500, but not as value-oriented as our peers.

A focus on income and growth of income

Another hallmark of our strategy is that we don’t design our portfolio solely around maximizing upfront yield; instead, we seek a balance of upfront yield and growth of yield. We believe it is important to discover how companies translate their earnings and cash flow growth into income growth for their shareholders.

Recent high inflation has served as a stark reminder of how important income growth is in protecting purchasing power in an inflationary environment. We focus on income growth partly because we don’t know how inflation will evolve in the future.

The current yield and growth of yield combination we seek can also include variable dividends. In addition to paying a base dividend, for example, a company might pay an additional variable dividend when times are especially good.

In 2022 when prices rose for commodities like oil and gas, some energy companies rewarded shareholders with a higher level of variable income because the cash flows of companies in this space were greater. As commodity prices fluctuate, these companies can reduce the variable dividend without impairing the base dividend they pay.

Even without these variable dividends, and even if a recession happens in the United States, it is our view that companies’ payout ratios won’t be severely impacted and could still grow.

Conclusion

In summary, our aim is to have a portfolio of high-quality, dividend-paying stocks that can deliver strong risk-adjusted returns through a combination of yield and growth of income.