The dividend yield is often the first thing a manager of a dividend fund looks at when analysing a stock. But not Ludwig Palm, manager of Flossbach von Storch – Dividend fund. His main focus is whether a company is able to increase its dividend in the long term.
“It’s not that important to us how much a company pays out in dividends today,” he says in an interview with Investment Officer. ‘We place more value on dividend security and the potential for dividend increases. A high dividend at any given time doesn’t tell me much. What matters to me is how high the dividend will be in 5 or 10 years’ time.’ That’s why Palm primarily looks at a company’s earnings projections, just like an ‘ordinary’ fund manager basically. ‘Whether a company is able to generate free cash flow and grow profits is what really matters. Dividend is just the result of that. I don’t completely ignore the amount of dividend paid, but dividend security and potential for growth are more important to me.’
Every company that pays out dividend is in principle eligible for inclusion in the fund. The portfolio of Flossbach von Storch’s global dividend fund therefore differs considerably from that of an average dividend fund. For example, there will be few dividend managers who, like Palm, invest in companies with a dividend yield of less than 1%, such as ASML or Tencent. ‘It is true that a company like ASML pays relatively little in dividend, though the dividend has increased by 264% over the past five years. At Tencent the dividend has increased even more, from 0.014 HKD in 2005 to 1.2 HKD in 2020. This means that the dividend is now even higher than the price of the stock at the time.’ This example illustrates Palm is not as much as dependent on dividend payments as most of its peers. Palm estimates about 70% of the returns he has made over the past 8 years come from price appreciation rather than dividend pay-outs.
No banks or cars
The logical consequence of Palm’s emphasis in his investment philosophy on the underlying profit growth of companies is that his fund is largely invested in the consumer goods, technology and healthcare sectors. Sectors in which dividend investors are traditionally overweight, such as banks and industrials, are absent. Palm does not invest in the big car makers either, which is exceptional for a German investor. ‘Many dividend funds are almost automatically invested in companies that pay a lot of dividends, but we are not.’
And Palm’s fund has benefited from this different approach. For example, in 2020 Flossbach von Storch Dividend achieved a return of around 6.5% after costs for its institutional share class, where most other dividend funds lost money over the year. After all, those high dividend payers in which Palm invests little or nothing are precisely the companies that have had to cut their dividends most as a result of the coronavirus crisis. According to research by Janus Henderson Investors, dividend payments fell by more than 14% in the third quarter of 2020. In the second quarter this was even more than 18%. The vast majority of companies in the Flossbach von Storch Dividend Fund actually increased their dividends last year, with only two companies cutting pay-outs.
An important reason why certain stocks sport high dividend yields is that their valuations are very low. ‘A company with a good cash flow that is growing must be highly valued in this stock market climate where the interest rate on bonds is zero or even below,’ notes Palm. ‘If a company is expensive, the dividend yield is generally not that high. If a company is cheap, valued at for example 10 times profit, it almost automatically means that it has an uncertain future ahead of it.’ And this makes the dividend pay-out uncertain.
Tobacco
That is why Palm, in principle, avoids companies of this kind. But he too makes exceptions. For example, the tobacco producers Imperial Brands and British American Tobacco, which are not exactly examples of growth companies, are both in the fund’s top 10. The dividends paid by these companies are simply so attractive that they are must-haves, he says. ‘Despite the headwinds the tobacco sector is experiencing, it is still extremely profitable. Cigarette production has been declining for some time now, but sales and profits have not.’ Palm realises that the tobacco industry in its current form is under threat, but he believes markets overestimate this risk. ‘Imperial Brands’ dividend, for example, is so high that the company only has to survive for six years for me to get my investment back.’
In addition, Palm has taken positions in the oil and gas sector in mid-2020, anticipating a cyclical recovery of the economy. ‘On all metrics, the sector’s valuations are very favourable,’ he says. Nevertheless, he emphasises this recovery trade remains a hedge for him, in case the economic recovery is going better than expected, as this could cause commodity prices to rise and interest rates to come under upward pressure. ‘Actually, it is of course insanely difficult to make a case for oil and gas. But if interest rates at the long end start creeping up, the valuations of growth companies will come under pressure. Hence the need to hedge this risk.’