Extract quarterly report 3Q2020

Outlook, Thoughts & Issues

Dividend yield: a strong source of stability and return for the portfolio

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By definition, our deep value strategy focuses on those areas of the market that are presently shunned or neglected. While we wait patiently for individual positions to catch up to their estimated true value, one important benefit supporting the intact long-term compounding record of the fund is its underlying dividend yield. For example, at the moment the portfolio’s weighted gross cash dividend accrual amounts to roughly 2.5% p.a. If we assume a 30% across-the-board non-recoverable withholding tax levy charged at source, the aggregate portfolio thus generates a current net dividend yield of 1.75%. This may not sound like much but in compounding terms this is a big number, especially seen in the context of what’s currently available on a so-called “low-risk” long-term investment such as government bonds. That is, if we apply a benchmark 10-year German bund yield of -0.50% as a ”riskless” investment, we get a sturdy 2.25% yield pick-up for our “risky” equity fund. Together with the expected growth of expected capital gains generated by our portfolio companies (which of course government bonds do not), the long-term profile of our fund is earnestly solid.

Let us consider a few noteworthy aspects of the dividend yield. First, so far in 2020 for example, the current dividend payout level has unsurprisingly been subject to a downward revision due to the Covid-19 pandemic as well for reasons related to the more generalized cyclical downturn evident in many industries within which our companies are active. Concretely put, slightly more than a fifth of our portfolio firms decided to reduce or omit their regular cash payout for the current dividend term. We are strongly convinced that both the virus- and cycle-related dividend reductions will normalize themselves in the form of higher payouts and reinstatements of regular dividends as business activity gradually recovers. Thus, the current dividend yield is artificially depressed if put in a context of a longer-term business perspective.

Second, as we have pointed out on many occasions, we believe that our investment approach to buy underappreciated businesses can inherently be expected to bear substantial potential for dividend growth as our portfolio selections are capable of improving their operating cash flows over time. In other words, not only is the fund’s underlying dividend payout attractive at the current level, but we also estimate that it will grow incrementally in the future—above and beyond the virus- and cycle-adjusted normalization factor explained earlier.

Third, dividends represent a highly beneficial factor in our money management activities. That is, let us assume for a moment that fund flows and portfolio adjustments (i.e., subscriptions and redemptions plus any net trades in existing positions) are neutral. In this case, then, the accumulated net dividend collections from our portfolio holdings would in principle enable us to buy a full additional position during a given 12-month period. In short, receipts from dividends enhance our flexibility and add precious options to how we chose to deploy the fund’s available cash.

And fourth, we maintain that dividends as a proportion of total return is generally underrated; actually the reinvestment of the same has been demonstrated by most observational studies to make up the majority of total return over time. Moreover, we believe that this proportion between dividends and capital gains becomes even more evident in the future given the likely scenario of a “lower-return” equity environment as foreseen by most rational market observers, macroeconomists and other students of long-term financial cycles. This point is especially important to consider in the case of all the savers who chose to structure their securities portfolio in terms of a balanced investment program (i.e., one part fixed-income and one part equity).

To conclude, it is clear that dividend yield continues to play a central role in our portfolio management strategy. The generation of dividends and the diligent reinvestment thereof has always been, and will remain to be, a significant pillar of the long-term return compounding equation. In fact, given its importance it seems quite surprising to us why it keeps being treated as a mere side note by common investment wisdom.

Sincerely,

Gregor Trachsel

Chief Investment Officer SG Value Partners AG