Two ways to generate cash returns from equities

While the Bank of England’s three-pronged monetary package launched on 4 August has been welcomed by equity and bond markets (not to mention many commentators and economists), the combination of an interest rate cut, more Quantitative Easing (QE) to lower corporate and Government bond yields and a new funding scheme for banks does not mean all is milk and honey for everyone.

The plan puts cash-rich investors further under the cosh, by depriving them of a reliable income from cash and Government bonds. Many will be forced to buy investment grade or junk debt, emerging market government debt property or equities, either directly or via funds, or even address more esoteric areas, such as peer to peer lending and alternative finance.

It is hard to quantify the impact of seven years of record-low interest rates and QE (with more to come) but one way of doing so is to look at the Pension Protection Fund’s 7800 index, which looks at the aggregate pension fund surplus or deficit across some 6000 firms. 

While correlation is not causation, it does seem clear that the lower interest rates go, dragging 10-year Gilt yields and therefore in turn annuity rates down with them, the bigger the deficit has become.

QE and record low interest rates look to be hurting corporate pension funds (and by implication private ones)

Source: Pension Protection Fund, Thomson Reuters Datastrea
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Even if higher bond prices may offset some of the pain caused by lower yields, investors buy fixed-income securities for just that – income – and not the prospect of gains which could still prove ephemeral over the life of the debt instrument.

This suggests investors could look to save more, not less, and possibly defeat the purpose of low rates and QE, which is to boost credit flow and stimulate consumer (and corporate) spending. 

Such is the law of unintended consequences, but such philosophising does not put money in the portfolio pot. In the event UK interest rates look destined to remain lower for longer – and with the threat of negative rates still far from entirely shaken off – many investors want to find secure income streams and pay low fees to access them, as cutting costs is a sure-fire way of boosting overall returns.

In certain cases, Exchange-Traded Funds (ETFs) can address both of these needs simultaneously. ETFs are traded funds designed to track and deliver the performance of an index or basket of securities and they can be bought and sold like a share.

So-called ‘smart beta’ ETFs create their own custom-made index, rather than a well-known benchmark, and then track this basket of securities, with the aim of providing the underlying assets’ returns, minus the running costs of the product.

Targeting a basket of cash-rich stocks that are capable of returning surplus cash to their investors seems like one potentially interesting strategy and stock market action in the UK this month so far backs this up. Shares in megabank HSBC jumped in August after the FTSE 100 stalwart announced a $2.5 billion share buyback, while life insurer Aviva’s shares also rose sharply when the company announced a 10% increase in its interim dividend.

In each instance the firm returned cash, although they used different mechanisms to do so, one using a buyback, the other a dividend.

Investors are unlikely to have the time or inclination to analyse the merits of specific firms, their balance sheets, cash flows and strategies, but ETFs mean they do not have to. 

Invesco's PowerShares Global Buyback Achievers UCITS ETF is listed on the London Stock Exchange, with the EPIC code of BUYB, as is the SPDR Global Dividend Aristocrats ETF, which has the EPIC code GBDV.

Investors can then choose which cash return mechanism they prefer, if income is indeed a key part of their investment plan, and it is therefore worth assessing the relative merits of the instruments and the strategies which they choose to follow.

Cash returns

The Invesco PowerShares Global Buyback Achievers ETF tracks a basket of securities which comprises the constituents of both the NASDAQ US Buyback Achievers and the NASDAQ International Buyback Achievers indices. 

The NASDAQ US Buyback Achievers Index is comprised of corporations that have effected a net reduction in shares outstanding of 5% or more in the trailing twelve months. The NASDAQ International Buyback Achievers Index is comprised of corporations that have effected a net reduction in shares outstanding of 5% or more in their latest fiscal year. 

For the record, the five largest firms in the basket tracked by the ETF at the time of writing are Russia’s Lukoil, US fast food giant McDonald’s, Canadian Pacific Railway, FUJIFILM of Japan and Swiss drug developer Actelion.

This helps to yield the following geographic weighting, with the US and Japan dominating. The UK has no presence at all, to reaffirm how dividends have generally been the preferred method of cash returns rather than buybacks.

The US and Japan dominate the weightings of the Invesco PowerShares Global Buyback Achievers ETF

Source: Invesco Powershares factsheet, Morningstar

It also shapes the sector allocations, with Industrials, Consumer Cyclicals and Technology representing 60% of the assets, so investors can judge whether the buyback programmes are sustainable and therefore whether these industries are ones to which they desire such active exposure.

The Industrials, Consumer Cyclicals and Technology represent the bulk of the Invesco PowerShares Global Buyback Achievers ETF’s assets

Source: Invesco Powershares factsheet, Morningstar.

Long-term plan

Yet buybacks are not to everyone's taste and the debate over which is ‘best’, dividends or buybacks, rages on. An investors tax situation and long-term investment goals will have a large say here, but the arguments in favour of dividends (and their reinvestment) remain compelling. 

Professor Jeremy Siegel's book Future for Investors demonstrates, in a US equity market context, how the highest yielding US stocks had consistently outperformed market over a 50-year view, and done so while offering lower-than-average volatility, as benchmarked by beta.

Stocks with the highest dividend yield have consistently outperformed in the USA

Dividend yield (quintile)	Return (per year)	Beta
Highest	12.8%	0.93
High	12.6%	0.84
Mid	9.8%	0.91
Low	9.2%	1.07
Lowest	9.5%	1.23

Source: Professor Jeremy Siegel, Future for Investors. Shows average annual total returns from 1957 to 2013, dividing S&P 500 index into five quintiles, weighted by market capitalisation.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Cash in the hand

Despite the positive case that can be made in favour of dividends, there is the risk that the payout could be cut in the event of a recession or sudden profit shock at a company. 

In the case of the FTSE 100, dividend cover looks a lot thinner than ideal. In a perfect world, cover would be more than two times, to leave some slack in case an earnings downturn or recession hits, but cover hit barely 1.3 times in 2015 and is not expected to reach 2.0 times until 2018 at the earliest.

In the event of an economic downturn this could leave dividend payments exposed to the risk of further cuts, bearing in mind that around a dozen FTSE 100 members have already cut their shareholder payout in the past 12 to 18 months.

Earnings cover for forecast dividend payouts from the FTSE 100 is skinnier than ideal

Source: Digital Look, analysts’ consensus forecasts
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

A good active manager should look to pick the consistent payers and dodge the cutters. To help mitigate this danger the SPDR Global Dividend Aristocrats ETF selects stocks that have not only a decent yield but also a 10-year record of stable or increased dividends.

For the record, the five largest firms in the basket tracked by the ETF at the time of writing are American midstream oil play Williams, .South African mobile telecoms company MTN, US printing play RR Donnelley, Finnish utility Fortum and Canadian energy investor Enbridge.

This yields the following geographic weighting, with America, Canada and the Eurozone leading the way, with the UK coming in at just under 10% of the portfolio. On this occasion, Japan has zero weighting.

The US, Canada and the Eurozone are the biggest geographic positions within the SPDR Global Dividend Aristocrats ETF

Source: State Street Global factsheet, Morningstar

The ETF’s biggest sector weightings are Financial Services, Utilities and Industrials the three biggest weightings, followed by Telecoms and Energy.

Financial Services, Utilities and Industrials are the biggest sector exposures within the SPDR Global Dividend Aristocrats ETF

Source: State Street Global factsheet, Morningstar

In both cases, the spread of assets differs considerably from that of the Invesco PowerShares Global Buyback Achievers ETF, something which may influence investors as they assess whether either instrument is appropriate for their portfolios or not. 

For and against

Thin earnings cover represents a clear and present danger to dividend-based strategies but there are risks associated with share buybacks, too.

History shows companies have a habit of buying stock back during bull markets (when their stocks tends to be more expensive) and not doing so during bear ones (when their stock tends to be much cheaper). 

For example, buybacks in the US peaked in 2007 and collapsed in 2008 and 2009 only to accelerate again in 2011 and 2012. 

This exposes investors to the risk management teams are buying high rather than low could therefore question whether executives are sufficiently objective when they sanction a buyback to show the market they feel their stock is undervalued. 

There is also the risk that firms buyback stock using debt, potentially weakening their balance sheets and competitive position in the long term (although the same danger lurks with dividends).

When it comes to buybacks, it may therefore be worth heeding the words of master investor Warren Buffett from his 2012 letter to shareholders: “Charlie [Munger] and I favour repurchases when two conditions are met: first, a company has ample funds to take care of the operational liquidity and needs of its business; second, its stock is selling at a material discount to the company's intrinsic business value, conservatively calculated.”

Acid test

It will be interesting to see how both ETFs do over time and whether or not one cash return approach proves more valid than the other.

At the moment, dividends have the edge. Since the October 2014 launch of Invesco PowerShares Global Buyback Achievers, the instrument has risen by 10.6%, while SPDR Global Dividend Aristocrats has gained 26.2%. Over the same period, the FTSE All-Share is up 10.2%.

Only long-term performance will determine whether buybacks or dividends offer greater value to investors

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Note however that the Invesco PowerShares instrument is priced in dollars on the above, as its local currency. Translating that into sterling gives performance a bump, given the pound’s plunge from $1.60 to $1.30 since October 2014, and on this basis the buybacks ETF has returned 38.8%.

Russ Mould
AJ Bell Investment Director