Executive summary

  • In our view, defensive dividend payers are too cheap in both absolute and relative terms
  • The current opportunity in defensive dividends has been created by conditions that we expect to unwind
  • We see attractive valuations across defensive value sectors like staples, pharma, telecoms and insurance


Growing defensive dividend-paying equities are too cheap

The Polar Capital European ex-UK Income Fund1 yields 4% net of withholding taxes. This represents a compelling spread over its local index and broader equity indices as well as our portfolio companies’ own credit and government bond yields. We believe this level of yield is likely to be higher than where inflation will settle later in 2022, therefore it offers a positive real yield at a time when many assets do not. We consider the pandemic to have been the ultimate stress test for dividends, as many unsustainable dividends were swept away. Attractive dividend yields post-pandemic are worth more in our view for two reasons. First, pandemic policies have made yield even more scarce across asset markets; second, these dividends have proven themselves to be more resilient and warrant a re-rating.

Despite the pandemic-related dividend carnage, our Fund has delivered a 5% dividend CAGR since inception in June 20152. An asset with a starting yield of 4% and a compounding power of mid-single-digits over the medium term will give a successful savings outcome. This contrasts sharply with a corporate bond yielding almost nothing or a growth stock on 30+x price earnings which in effect has pulled forward future compounding power into today’s valuation.



Dividend CAGR since inception

Dividend CAGR since inception

Source: Bloomberg, Polar Capital. January 2022. Polar Capital European ex-UK Income Fund GBP S Dist Hedged share class. Past performance is not a reliable indicator of future returns. The money invested in a fund can increase and decrease in value and past performance is not a reliable indicator that you will get back the full amount invested.

As the chart below shows, our dividend yield is relatively high because it grew faster than the index pre-pandemic and held up much better during the pandemic.

Fund yield versus dividend yield

Fund Yield Versus Dividend Yield

Source: Bloomberg, Polar Capital. January 2022.  Past performance is not a reliable indicator of future returns. The money invested in a fund can increase and decrease in value and past performance is not a reliable indicator that you will get back the full amount invested.

The current opportunity in defensive dividends has been created by conditions unlikely to persist

Investors are used to the concept of ‘reaching for yield’ in asset markets, that is to say a need to take more risk to achieve higher yields. The current high dividend yields of defensive sectors relative to the rest of the market are relatively unusual and reflect poor sentiment towards dividends.

  • The usual defensiveness of dividend stocks was compromised by the fact that many dividends were temporarily paused during the spring 2020 sell-off. This meant they did not hold up as well as we felt they should have during the pandemic panic. This was then exacerbated by them lagging a very strong stimulus-driven rebound in cyclicals.
  • The extreme valuation re-rating of many assets has rendered dividends out of favour, with many investors understandably preferring to focus on capital gains. From the starting valuation of many equity markets, we expect the weight of dividends in total return to increase back to historical importance as extreme monetary policy is normalised.


The lack of need to reach for yield is demonstrated in the Fund’s factor skews in the chart below. The portfolio has a slight positive skew towards quality (especially stability of returns), while offering a much higher dividend than the broader index and a meaningful skew to value characteristics. We currently hold no stocks in the most cyclical parts of the market (a zero weight in banks and autos), so see relatively low risk to our dividend from any deterioration in the macro.

Fund style/factor characteristics

Fund Style Factor Characteristics

Source: Polar Capital. January 2022.  Past performance is not a reliable indicator of future returns. The money invested in a fund can increase and decrease in value and past performance is not a reliable indicator that you will get back the full amount invested.


We see attractive valuations across defensive sectors like staples, pharma, telecoms and insurance

The Fund’s absolute cheapness (see the chart below) has been driven by defensive value sectors that we like materially lagging the broader market. The valuation gap between defensive value stocks and quality growth stocks has become extremely wide. Data from strategists at Citi show a basket of expensive quality stocks currently trades on 37x earnings, compared to a peak of 45x in 2021 and just 25x in 2018. In contrast, a basket of defensive value stocks currently trades on about 10.5x earnings, compared to 15x in 2018. In our view, the valuation of the most loved stocks became unanchored in a period of excessively easy central bank money and has further to correct.

Valuation gap and absolute portfolio cheapness

European ex UK Income

FCF Yield

P/E x

Div Yield %

P/B x

ND/EBITDA x

Median – Portfolio

5.8%

15.7

4.0%

2.2

1.9

MSCI Europe ex UK – Median

4.0%

17.5

2.9%

2.2

0.8


European ex UK Income non-Financial positions:

FCF Yield

P/E x

Div Yield %

1YR ROE %

ND/EBITDA x

Median – Portfolio ex Financials

5.8%

16.9

3.7%

14.9%

1.9

MSCI Europe ex UK – Median ex Financials

4.0%

21.1

2.0%

15.4%

0.8


European ex UK Income Financial positions:

P/B x

P/TB x

P/E x

Div Yield %

1YR ROE %

Median – Portfolio Financials

1.2

1.3

10.8

5.6%

10.4%

MSCI Europe ex UK Financials – Median

1.0

1.0

10.7

4.5%

9.2%

Source: Bloomberg, Polar Capital. January 2022.  Past performance is not a reliable indicator of future returns. The money invested in a fund can increase and decrease in value and past performance is not a reliable indicator that you will get back the full amount invested.


Our preferred defensive dividend sectors are consumer staples, large-cap pharma, telecoms and non-life insurance. Most of the stocks we own in these sectors trade on less than 16x earnings. The table below shows the compelling valuations of our top-10 holdings.

Valuations of top-10 holdings

Valuations Of Top 10 Holdings

Source: Bloomberg, Polar Capital. January 2022. It should not be assumed that recommendations made in future will be profitable or will equal performance of the securities in this document. A list of all recommendations made within the immediately preceding 12 months is available upon request.


Conclusion

Our investment process is based on buying good companies when they are out of favour to generate attractive dividends, without compromising on either growth or quality. We believe the Fund’s dividend growth of 5% since inception demonstrates its ability to deliver compelling compound dividend growth despite not owning the most expensive parts of the market. In a world of expensive assets, we see a unique opportunity in the kinds of company we like.


1 Polar Capital European ex-UK Income Fund GBP Class I Acc £ share class.
2 Polar Capital. Class S Hedged GBP Distribution share class.