This is the first article in a series highlighting how to invest differently in the current macro environment. We take a step back from crowded cyclical views to focus on the longer-term journey for investors, and what they really need to be thinking about to generate consistent outperformance.
Diversification, discount rates, duration, dividends and …
In the comedy movie, “Dodgeball: A True Underdog Story”, Patches O’Houlihan says to a team of misfits:
“You’ve got to learn the five ‘d’s of dodgeball: dodge, duck, dive, dip and dodge!”
What stands out in this quote is the almost forced repetition of the word “dodge”, to make a catchphrase.
In this article, we take a leaf from Patches. We discuss the five ‘d’s of investing: diversification, discount rates, duration, dividends and … diversification. They are related concepts that overlap in scope. The frame serves the purpose of exemplifying the basics of successful investing across economic cycles, with diversification being critically important. The question is how we best achieve diversification in the current market climate via the other ‘d’s.
In the sections below, we explore what each of the five ‘d’s mean, and how we see them currently interacting. We begin with the drivers of stock valuations – discount rates, duration and dividends, and then move on to how investors have become too focused on some components over others. We discuss how this behaviour is leading to crowding in parts of the market and why it is important for investors to search for alternatives to diversify or spread risk. Among these alternatives are investments that focus on dividends, small and mid-cap exposures, and commodities.
Discount rate, duration and dividends
One method of valuing a company involves summing the dividends it pays through time, subject to the condition that a dollar tomorrow is worth less than a dollar today, as a dollar today can earn interest. Not only could an investor earn interest today, but they could look at the next best alternative investment, “r”. In a highly simplified world, where: (1) a stock offers to pay a dividend “d” next year, with (2) “d” growing by a steady annual rate “g”, and (3) investors discounting future dividends by the annual rate “r”, the value of the stock “P” equals “d” divided by the “r” minus “g” spread. This valuation framework is known as the Gordon Growth Model.
Figure 1: The Gordon Growth Model of stock valuation
Source: Gordon, WAM
While an oversimplification of the real world, the Gordon Growth Model helps us to understand the key drivers of stock valuation.
Stocks gain in value when dividends “d” are higher, when dividend growth “g” is stronger, and when the discount rate “r” is lower, with the latter two factors defining the concept of duration.
Over the past few decades, discount rates have fallen with interest rates as inflation has moderated. But the global trend of moderating inflation has paused post-pandemic. We have witnessed rising rates and more uncertainty about inflation, driving up discount rates on equities. And we have seen investors periodically question the valuations of long-duration growth stocks.
Diversification
Diversification is the idea that in a portfolio of different investments, some might go up, while others go down – but on average, the portfolio wins, especially in the long term. Diversification is not an excuse for sloppiness in selecting investments. Rather, it is an especially useful risk management tool, applied by the best investors in the world to spread their risks across their many high conviction ideas. We think diversification matters as much now as ever, but it is hard to find among the more popular investments such as exchange traded funds (ETFs).
Mathematically, diversification requires the returns on different investments to be less than perfectly correlated – preferably zero or slightly negatively correlated. For example, in a two-security portfolio (A and B), the price of A should not move exactly up and down each day in sync with fluctuations in the price of B. Rather, there should be days when the price of A falls or stays unchanged, while the price of B rises, and others where they might move together.
Passive investing is predicated on diversification working well in the long term, such that investors can largely “set and forget” their portfolio allocations without having to actively watch or manage them.
In an investment portfolio consisting of stocks and fixed income instruments, a simple 40/60 split between the two asset classes is supposed to produce acceptable returns with less volatility than holding each in isolation. It is no secret that passive investing has significantly gained in popularity over the past decade or so, not the least because it is a low-cost, and low-intensity way of investing. However, in a well-functioning or efficient market, we need to have a balance between passive and active investors. There are times when the balance becomes skewed too far one way or another, because of the wisdom of crowds, reinforced by policy maker behaviour to support financial markets. And we think that now may be one of those times.
Consider for example that in the US, seven large technology stocks (the so-called “Magnificent 7’) make up roughly 35% of the entire stock market and drive most of its daily movements. These stocks fit the bill of long-duration growth stocks and have historically been major beneficiaries of either lower interest rates or at least, lower interest rate uncertainty. If we were to see higher rates or higher interest rate uncertainty, we could easily see a large part of the stock market come under pressure, as well as fixed income securities, noting that fixed income securities must fall in price to offer a yield competitive with prevailing interest rates for new investors. In these circumstances, diversification in a standard 40/60 portfolio would break down, making passive investing a much more volatile exercise.
Figure: “Magnificent 7” share of US market capitalisation
Source: Bloomberg, Wilson Asset Management
History suggests that stock returns tend to become more correlated or ‘in sync’ with fixed income returns following a rise in inflation uncertainty. Consumer surveys tell us that although expectations for future inflation are moderate on average, there is a wide spread of views among members of the general public, suggesting that inflation uncertainty is indeed quite high. In such circumstances, we would expect stocks and fixed income securities to be quite highly correlated. High inflation and inflation uncertainty push up rates, to the detriment of fixed income security valuations. High inflation could benefit stocks to the extent that it reflects pricing power for companies – but it hurts them to the extent that it is cost driven. More importantly, high inflation uncertainty hurts stocks because it raises policy uncertainty as well as the discount rate investors apply to future cashflows.
Figure 3: Correlation between US stocks and fixed income
Source: Bloomberg, Wilson Asset Management
Figure 4: US inflation uncertainty
Source: Bloomberg, WAM
Without prescribing a view as to where interest rates go next, the key thing for longer-term investors to beware of is the likely lack of diversification in conventional passive portfolios. Therefore, such investors need to be on the lookout for new sources of diversification outside of the most popular (concentrated) stocks and government bonds. This inevitably means looking where the crowd has not – that is among the investments that have lagged in recent years. Small- and mid-cap stocks clearly fit this bill, as natural alternatives to the “Magnificent 7” – and there has been some rotation into this space over the past few quarters. Commodities are another place to explore, subject to one’s convictions about China and global inflation. We also think that dividend strategies are worth considering, particularly in the Australian context where franking is supportive.
Dividends
As noted at the outset of this piece, the five ‘d’s of investing are not mutually exclusive. They are chosen with the purpose of emphasising one of the ‘d’s with the others serving as complementary. That d is diversification. So far, we have discussed discount rates and duration (growth) … but what about dividends?
We have nothing against investing using portfolio levers of duration or discount rates. But to have a truly diversified portfolio, there must be an appropriate balance between duration, discount rate and dividend factors. And right now, this balance is a little bit too skewed towards duration. To restore appropriate diversification, the market needs to place a higher value on short-duration exposures, meaning that higher dividend stocks could come into focus. These companies might choose to grow their dividends by taking advantage of falling rates and borrowing more. But if they are not plays on leverage, they are short duration exposures. As short duration exposures, they may be more sensitive to short-term swings in the economic cycle – but there are ways of filtering out businesses that investors consider too cyclical.
In conclusion, we think that finding the best dividend payers in the market on both short- and long-term horizons is critical to obtaining more portfolio diversification, if not higher returns. Dividends are an important means to the end goal of diversification. Also, a thorough investment process that filters for quality is important, so that investors can identify companies that have the ability to continue paying these dividends.
