Baillie Gifford: Breaking down challenges for income investing

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Professional Adviser
clock • 2 min read
Baillie Gifford: Breaking down challenges for income investing

Dividends are becoming a greater consideration for investors after more than a decade when income has played second fiddle to capital growth, says Baillie Gifford Global Income Growth Fund client service director, Seb Petit.

However, he says focusing on dividend growth, rather than a high starting yield should steer investors towards more resilient income.

The environment of the next decade is likely to be less forgiving for companies, with higher borrowing costs, weaker economic growth and structurally higher inflation. This will test companies' business models. Over the next ten years, Petit believes there will be more shocks and companies need to be well-prepared. Those companies with pricing power and balance sheet strength should be in a better position to weather any storms.

Petit gives the example of Microsoft versus RWE Group. In 2011, RWE had a dividend yield of over 7% and it appeared a good choice for an income investor. However, the dividend proved unsustainable. The company needed to pivot away from coal and nuclear energy, requiring huge cash flow that ultimately dented the dividend payment.

The fund seeks to uncover growth companies with sustainable business models and resilient dividends, holding them for the long-term. He points out that nine out of top ten holdings in the Global Income Growth fund managed to maintain or raise dividend during the pandemic and the fund distributed more in 2020 than in 2019.

In contrast, Microsoft's starting yield was just 2.3%. However, the income has grown by 10% every year. An £100 investment would have generated income of £55 over the period, compared to £26 from RWE. The capital returns have also been very different. Too often, a high starting yield means a company is over-distributing or has run out of growth opportunities.

Petit admits that dividend growth strategists have been hit by the shift in interest rates. Companies that are growing quickly tend to have more of their value in future cash flows, and valuation multiples are dented by higher rates. However, this has provided opportunities to invest in companies that previously looked too expensive. The fund has recently bought L'Oreal, for example.

The fund has not been tempted to rotate in traditional value areas such as oil companies or banks. Fossil fuels may have benefited from a short-term bounce in commodities prices, but the energy transition is accelerating. Banks tend to be commoditised and driven by macroeconomic events. As such, their resilience is relatively low, says Petit.

Instead, the fund holds companies such as PepsiCo, Nestle or semiconductor group TSMC, which have strong pricing power. These companies will find it easier to recoup increases in input costs and preserve their margins. Companies need to offer clear value in a more challenging environment.

 

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