Analysts at Deutsche Bank and Fitch are applying factors from the ‘real world’ to the field of dividends, with some startling results that are often quite contrary to traditional equity income strategies.
Reported numbers are based on methods “whose objective is to justify the legal requirements of an accounting system”. Significantly, economic earnings take into account the effect that real-world economic variables, such as inflation, have on companies’ earnings. The figure produced is a ‘real earnings’ number, and is sometimes worlds away from reported numbers investors base their trading, forecasts and ratios on.
In the case of Exxon in 1982, for example, healthy reported net income of $4.2bn under-reported accounting became a $296m loss after the company adjusted these results for general inflation.
Deutsche’s CROCI team makes five adjustments – for inflation, financial leverage, economic life, intangibles and goodwill – to move from an accounting to an economic basis.
It employs local currencies for plant, machinery and earnings of multi-jurisdictional firms; applies discrete asset-specific depreciation schedules where needed; and brings back on-balance sheets items that firms have placed off-balance sheet.
Curto says: “Ultimately, you have to have a reconciliation with real earnings [because] companies pay dividends out of real earnings. You have to find the stocks that are cheap on that measure, not on the nominal [earnings] measure. Companies that do not make real money in real terms, it will catch up with them and they will cut their dividends.”
The CROCI team produces an equal-weighted index of 50 of most attractive stocks, filtered for three sustainability criteria to remove firms with high financial leverage, high volatility and the lowest real profitability. The index, CROCI Global Dividends index, is available in certificate format or on a platform. About €3bn follows the index presently.
The portfolio is rebalanced quarterly and targets stocks with “high dividend yields and low economic PE, so combining value on both cash generation and cash distribution,” according to a CROCI report from May. The report showed the index had zero weightings to utilities and financials, and only 4% in telecoms.
Overall, says Curto, dividend investing “thinking of an equity like a bond” – still makes sense, not least because the low growth environment expected in the developed world could cap real earnings growth. But different analysis to identify ‘dividend stocks’ will result in very different sector preferences.