After a decade where a handful of technology companies have done the heavy lifting on returns, a portfolio shaped around these giants may not be appropriate for the environment today. Quality companies, with consistent income and growth characteristics, are one option for investors looking to diversify.
The Magnificent Seven Two
Seven stocks dominated in 2023 – Nvidia, Tesla, Microsoft, Apple, Alphabet, Meta, and Amazon. Each had a claim to be a potential winner from the Artificial Intelligence revolution, even if it was not yet clear which would translate an exciting idea into real-world revenues. However, by the start of this year, two stocks were pulling away – Nvidia and Meta – while the remainder were either delivering index-like returns or, in the case of Tesla and Apple, significantly underperforming.
This shows that fashionable acronyms aren’t very helpful if a company is not delivering against expectations. Markets are becoming more discerning and focused more forensically on fundamentals. This reflects a changed economic backdrop: interest rates are higher and are unlikely to move back to the lows seen in the 2010s, while inflation is also likely to remain structurally higher. If low-interest rates flattered growth strategies, this is an environment likely to favor different approaches. The one that has worked so well over the last decade will likely be inadequate for this new reality.
Caution is needed
While US economic growth figures have continued to show strength, there are signs of fragility. Employment is at all-time highs, and at the margins, companies are starting to announce layoffs. Strong employment has sustained consumer spending, even as the savings buffer has started to drop. If it starts to waver, it could weaken economic growth.
There are still intractable areas of inflation. The most recent CPI data showed energy and shelter costs rising, while areas such as car insurance have also proved persistently high. The last mile on pushing inflation back to 2% may be trickier. There is often a ‘second wave’ of inflation and the US Federal Reserve is likely to be cautious on rate cuts until it has a full picture.
The market is currently pricing in a relatively bullish scenario, which sees both rates come down and economic growth accelerate. The probability of a ‘hard landing’ has not been largely discounted. We believe some caution is warranted and prices in some parts of the market have over-reached. This argues for a more defensive tilt to a US equities portfolio than investors have taken more recently.
A potential rotation
The US is known as a growth market, but this is a relatively recent development. The past decade has seen dividends fall as a percentage of total returns, but this is an anomaly produced by low-interest rates. In the long term, dividends matter. The contribution of dividends to total return is between one-third and 50%. We believe traditional dividend-paying companies will revert to become more important in an environment of higher interest rates and inflation.
Crucially, these companies are to be found in a range of sectors, not simply in traditional ‘income’ areas, such as utilities, real estate, and telcos. That allows us to build well-diversified portfolios and find value across the market.
A sign of quality
We also find that dividends are increasingly a badge of quality for companies. In markets focused on growth, paying a dividend can be seen as a sign that the company can’t find growth opportunities. That is not the case today. We find that the companies can pay a dividend and invest strategically in their business.
It can also be a sign of discipline. It shows that companies are not chasing every incremental project but are focusing on appropriate capital allocation. It shows that they have strong balance sheets and cash flows.
Final thoughts
We believe that the type of defensive, cash-generative, dividend-paying companies that we hold are likely to be valued by investors at a time of uncertainty. The US election later in the year adds another dimension to US markets. While we don’t believe either outcome will make a significant difference in the longer term, it has the potential to create some short-term noise.
There are reasons for caution in US markets today. Investors need to ensure their US equity exposure is balanced, and appropriate for the current economic environment, rather than the one that has just finished. High-quality income-generative companies have an important role in portfolios from here.
Important information
Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security.
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