Stephen Thornber of Threadneedle Investments reveals his investment process in creating a robust income-generating equity portfolio, and explains what investors should look for.
Date: June 2012
First, there must be a dividend yield of over 4%, which he said is a high hurdle rate but one which he thinks is appropriate and gives him a diverse opportunity set of around 1,600 companies globally.
His second focus is growth, so he works on the basis of a minimum of 5% earnings growth and 5% dividend growth, he explained. This means he is investing in companies which are dynamic and developing, rather than falling into what he calls “value traps” of stagnant companies which just pay dividends out of debt.
The third focus is on sustainability, said Thornber, which refers to a sound financial structure and balance sheet to support the business as well as its dividends. In line with this longer term focus he said he looks at gearing at less than 75% and payout ratios of greater than one-and-a-quarter. This is because while he wants to see the company returning large chunks of its profit as dividends, he also wants it to retain some of the profits to reinvest to generate the growth he is looking for.
On the global basis, Thornber said his strict criteria still presents him with a wide selection of available stocks – ranging from consumer discretionary to energy to telecoms and utilities.
What to avoid
When investors are assessing different dividend strategies, Thornber said they should look for managers which have demonstrated a process and a philosophy which has delivered over time, and for managers which have also provided a dividend policy which is more defensive to provide downside protection in weak markets.
It is also important to look for managers who keep their strategies simple, rather than using dividend-capture or hedging tools such as puts and calls, and then using those premiums to boost the income stream, he explained.
Instead, Thornber said the income stream should come from the natural generation of the dividend flow from the underlying investments.
Misconceptions with income strategies
According to Thornber, probably the key misconception among investors when they hear the words “income strategy” or “dividend strategy” is that they immediately think of low growth and deep value – but he said this is not the case.
As a result he said this works well within a balanced portfolio to provide a range of styles to ensure protection and diversification.