Many analysts, investors and companies associate quality with things like strong sales or earnings per share growth, regular share buybacks, big mergers & acquisitions, etc.
But in reality, the only true measure of economic value creation is the Return On Capital Employed (ROCE). In very simple terms, this means the return generated on the money the company needs to run its business.
Sustainable competitive advantages and barriers to entry are key to enabling quality companies to grow and maintain a superior ROCE over long periods, despite competitive pressures. Such advantages may be distribution networks, captive installed bases, licences, patents or brands.
On average, the companies currently held by BL-Equities Dividend maintain an ROCE of 18% compared to around 8% to 10% for companies in the main regional equity market indices. This emphasis on quality is a feature shared by all our equity funds.
Why focus on equities offering dividends?
Over the long term, dividends account for a significant proportion of the total return from equity markets.
Equities are the only asset class in which the cash flows generated are automatically reinvested to go on to produce more cash flows, and sometimes offer a dividend along the way, which may also grow.
Also, in today's context, I find it hard to understand why a long-term investor would buy some types of bonds knowing in advance that they will lose money if they hold them to maturity, even before factoring in inflation.
However, you have to be selective because not all dividends are equal, nor without risk. A very high dividend yield often reflects a valuation that has taken into account problems affecting the underlying company, and that dividend may soon be cut or even cancelled.
We focus solely on dividends from quality companies which are attractive in absolute and relative terms, sustainable because they are covered by cash flows, and have growth potential. BL-Equities Dividend currently offers a gross weighted average yield of 3.1%. The companies in our portfolio have increased their gross dividend per share by 7% p a on average over the last 5 years.
Aren't companies that pay dividends, by definition, short on growth potential?
That can sometimes be the case. However, the companies that we look for have a sound business model and limited investment requirements. They are able to invest in their activities to generate profitable growth and pay attractive dividends at the same time.
Moreover, the trends driving the growth of our companies are many and various: Coloplast is benefiting from an ageing population; Microsoft is dominant in the cloud; urbanisation in Asia is boosting business for KONE, the leader in elevators and escalators; LVMH and aircraft engine manufacturer Safran are profiting from the increase in disposable income in emerging markets; Rockwell is at the centre of industrial digitalisation and automation; while more rigorous standards, the proliferation of products and brands, shorter innovation cycles and the increasing demand for traceability are helping Intertek and SGS, the champions of the ‘test, inspection, certification' sector, and Givaudan, world leader in flavours and fragrances.
These are just a few examples and they also serve to show that BLI equity funds are not hemmed in by a particular theme. In addition, because the companies in BL-Equities Dividend offer added-value products and services, they can rely on their capacity to raise their prices. This is crucial as the objective is not growth at any price but profitable and relatively regular growth.
Jérémie Fastnacht is fund manager of the BL Equities Dividend fund at BLI - Banque de Luxembourg Investments. The views expressed form part of a recent blog post.