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Covid-19 behavioural change has impacted many companies’ performance

And why favouring good dividend-paying companies has paid off for Marriott Investment Managers: CIO Duggan Matthews.

RYK VAN NIEKERK: Welcome to this Market Commentator podcast. It’s my weekly podcast where I pick the brains of leading investment professionals. My name is Ryk van Niekerk and my guest today is Duggan Matthews. He’s the chief investment officer at Marriott Investment Managers. Duggan, thank you so much for joining me.

Marriott issued a very interesting press release, and it states that the behavioural changes we have seen since the onset of Covid-19 have had a massive impact on the performance of many companies.

You state that if you disregard the largest 30 stocks by market cap in the S&P 500, the index was in fact down in 2020, which is in stark contrast to the 18.4% total return the index delivered as a whole. Is it the case that if you did not pick the shares in the top 30 you would have missed the boat?

DUGGAN MATTHEWS: Hi Ryk, and just first of all thanks for having us on your show again. I think that’s a fair comment. I just think that the performance of most of the stocks making up the S&P 500, or the biggest 30, is more closely aligned to reality.

For most of us 2020 was a very difficult year, a very difficult business environment for most businesses on aggregate. And it was just, I suppose, a few very big players in the digital space that were the beneficiaries of Covid and really drove the good outcome when you look at the S&P 500 and that 18% return you spoke about.

I think it’s difficult for investors out there to comprehend such an outcome when we’ve all been struggling as much as we have, and that gives some colour to that outcome.

For 470 companies in the US it was difficult, and that was reflected in their performance.

RYK VAN NIEKERK: I think in many ways it would have been luck that led to some fund managers holding the stocks before the onset of Covid-19, because they were already expensive then. But let’s talk about the stocks under the top 30 – what happened there?

DUGGAN MATTHEWS: I think they didn’t perform well because the economic environment that they operate in was obviously very, very difficult; that’s an understatement. So obviously their earnings were more linked to the economy, to the real world, to what’s happening – as I say the real world, not the digital world. And hence their earnings growth was under pressure and dividend growth as well, whereas the companies operating in the digital space obviously benefitted from people migrating towards a more digital way of life. There are just this handful of big players there, as opposed to most businesses which provide goods and services for the real world.

RYK VAN NIEKERK: Duggan, stock selection of course is absolutely critical. But when you look at many of the portfolios of South African asset managers, you see very similar names. They hold shares in the top 50 of the S&P 500. Sometimes they focus only on the top 30.

But I assume if you want to find that 10-bagger, you will need to look at smaller companies. How do you go about searching and selecting these companies?

DUGGAN MATTHEWS: We’ve got quite a rigorous process that we go through to select stocks.

For us, it’s actually not about tech, really, it’s about quality, predictability and resilience. So we favour I suppose more boring, steady companies over flashy, high-growth companies. And those type of companies typically fall within the consumer staples sector within the more industrial parts of the markets. And those companies tend to be able to produce reliable dividend growth consistently over many years, decades.

A good example would be a company like Unilever or Johnson & Johnson or Coca-Cola, all companies that have managed to increase their dividends 40 or 50 times in a row. So we really focus on producing portfolios that, first and foremost, can produce a reasonable yield for investors, a decent dividend yield. And then we want the dividend that we distribute to grow consistently over time.

As I mentioned earlier, those companies typically fall within more traditional sectors like consumer staples, industrial companies, healthcare companies – those type of companies.

RYK VAN NIEKERK: I’m looking at your World Equity Fund and you hold shares in some pretty big top 30 S&P 500 companies – Verizon, Microsoft, Visa is in there, McCormick is in there, Procter & Gamble, Johnson & Johnson. How many shares are in the portfolio and how many can be regarded as these big mega companies?

See: Marriott First World Equity Fund fact sheet

DUGGAN MATTHEWS: It would be around 25. So we hold a fairly concentrated portfolio. They are all typically big, well-established companies that have been around for a very long time. They all have very good dividend track records. I suppose where we are quite different is that we own none of the Fangs (Facebook, Amazon, Netflix and Google), for instance. So there’s a big point of difference.

We own a few tech-centric businesses like Microsoft or Texas Instruments, but they are part of the few tech-type businesses with very good dividends that provide integrated software at the end of the day, software that we can’t go without. They fit the bill that we are looking for in terms of predictability – all big established companies.

Quite a point of difference, though, is that if you look at the S&P 500, I think 30% of that index is now tech and our portfolios obviously have a much lower exposure to that sector, favouring more traditional, solid, stable industries.

RYK VAN NIEKERK: You also state in the press release that dividend payments globally declined by around 20% during the lockdown. The reason [is that] these companies are trying to protect their cash during these uncertain times. How does that affect your decision-making?

DUGGAN MATTHEWS: I think what we were really pleased about is that none of the companies that we held in the portfolio – all 25 of those stocks – cut a dividend. So I think when we reflect on 2020, we are pleased with how the portfolio held up. We are pleased with the dividend growth that we produced, and it obviously validates the filter process that we go through in selecting stocks because, on aggregate, as you mentioned, [there was] a 20% fall in dividends. And worldwide, across all companies and geographies and on aggregate, the distribution our fund paid out would have increased by about 6%. And that’s exactly what this portfolio is all about. It’s about the resilience, predictability and a good consistent income flow to investors.

If you look at the portfolio today, maybe tech has been the flavour of the last decade – but as you rightly pointed out [it has] pretty stretched PE [price-earnings] multiples [and] very low yields – whereas these type of old, traditional, rock-solid quality businesses are still offering investors a good dividend yield and a sensible PE multiple.

RYK VAN NIEKERK: I’m looking at the World Equity Fund fact sheet, and the one-year income return was 2.2%, which was more than the actual price return. So it does make a big difference.

DUGGAN MATTHEWS: Yes, absolutely. It’s part of what generates consistent outcomes – having a dividend to reinvest into the portfolio and to accumulate more shares in these great dividend payers. Marriott is all about helping investors build income streams for when they decide to retire and they’re looking for a source of income from their investments. We couldn’t think of better investments to own for a lifetime than the type of companies that you see in that fact sheet, with the likes of P&G, Coca-Cola, Unilever, Colgate-Palmolive, Johnson & Johnson. They are the best dividend-paying companies in the world.

RYK VAN NIEKERK: It seems like Verizon has a dividend yield of 4.2%, Coca-Cola 3.1%, Microsoft 1%, and McDonald’s 2.4%. If you compare that to South African companies’ dividend yields, it seems slow, but obviously it’s in dollars.

DUGGAN MATTHEWS: I think that’s a big point of difference there. Obviously we’ve much higher inflation here in South Africa. averaging between 4% and 6%. If you look at the US, obviously your inflation rate is averaging between zero and 2%. So when you consider that’s a hard-currency income stream coming your way – a 2% to 3% yield in an environment where bond yields at the moment are 1.5%, cash interest rates are zero – when you take all of that into consideration, it’s quite a compelling income proposition because you are going to get that income which is more than bonds and cash, plus you’re going to get capital growth over time.

What’s really interesting, Ryk, is these companies, we believe, are great inflation hedges because they produce the goods and services that constitute the bulk of the consumer basket. So if they don’t increase the prices of the goods and services they produce, we are probably not going to see inflation.

So a great inflation hedge. There you’ve got a yield of 2.6% with a 6% growth outlook. And then if you consider the US 10-year inflation-linked bond yield, which I think is currently sitting at -0.8%, that yield differential there is a sure sign of value from our perspective.

RYK VAN NIEKERK: I’ve spoken to many fund managers, portfolio managers, over the years and I cannot remember that anyone has actually highlighted foreign dividends as a key investment priority. Do you think that South African investors look very closely at the dividend potential of companies before they invest?

DUGGAN MATTHEWS: It’s a great question, Ryk. I think our supporters and the investors with Marriott do. This has been a philosophy that we’ve employed for over 20 years. But I think bulk investors are looking for a maximum total return. That’s the typical behaviour. But there’s not just one way of deriving an outcome. Dividends can form a meaningful part of the return – accumulating more shares – and good dividend-paying companies helps over time. And then if your priority is predictability and certainty of outcome, as opposed to maybe just trying to maximise that outcome at all costs, then this, we believe, is a sensible, more conservative way of achieving that goal. I think it’s important to realise that often equity funds kind of sit under one banner, just being equity funds. But what constitutes those portfolios can be very different and therefore the risk inherent in those portfolios can be very different.

RYK VAN NIEKERK: Yes. But it can also stabilise total returns in a low-growth environment like we’re currently in.

DUGGAN MATTHEWS: What we saw with this portfolio is that it held up very well when we initially went into the crisis, and that speaks to the resilience of the businesses and the dividends that you get. But they maybe didn’t recover as much because obviously the economic stimulus that got pumped into the system juiced up returns from value stocks and less predictable, more cyclical companies.

But I think with this type of portfolio what you know is that in good times or in bad times your results should be fairly steady and consistent because, as you mentioned, you’re going to get a consistent income flow. And then, as I mentioned earlier, most of the companies we invest in have never cut a dividend over multiple decades. And when they go through crises, because of the nature of their business models, what they sell, the fact that they produce things we can’t go without, they tend to grow in those times consistently. And that leads to resilient performance and more predictable performance. It may not be the best performance, but I think you have a lot more certainty around the outcome.

RYK VAN NIEKERK: Now it’s notable that you don’t hold Berkshire Hathaway, but they never pay a dividend. So is that the reason why it’s not there?

DUGGAN MATTHEWS: Yes. That’s not a long story. That’s exactly the reason. It’s not that we’ve got anything against Berkshire Hathaway. It might complement the portfolio quite nicely. Warren Buffett is a fan, as we know, of dividend-paying companies, and he holds that within that vehicle – those type of investments. But yes, Ryk, it pretty much boils down to the fact that that company doesn’t pay a dividend.

RYK VAN NIEKERK: Have you changed the portfolio much during the past year?

DUGGAN MATTHEWS: No, we haven’t. We haven’t felt the need to make big changes to the portfolio whatsoever. Our portfolio turnover in these funds is very low.

We try and adopt a buy-and-hold investment strategy, and we feel very disappointed in ourselves if we are forced to sell out of a stock within five years. We are slow to buy into a stock, because we want to do our homework right; we are looking for long-term investments that can grow consistently over time.

As I mentioned earlier, none of those companies cut a dividend during Covid, where dividends on aggregate fell 20%. So we felt no need at the end of the day to make any fundamental changes to the portfolio.

RYK VAN NIEKERK: Does this approach reduce risk?

DUGGAN MATTHEWS: I think it’s a low-risk equity approach. As I mentioned earlier, there are small caps, there are so many different approaches to equity investing. It all kind of gets lumped under one banner being “equity”, which is all supposed to be high-risk. But there are many different approaches to equity investing. Some are more prone to risk and volatility, others are more conservative. So I think this type of strategy is a more conservative strategy for investors prioritising some form of income flow and prioritising more predictability with regard to returns and resilience in difficult times.

The reality is we feel it’s far more difficult to predict the future of a technology business or a cyclical business or a resource company than it is to predict the future of a company like Coca-Cola or Diageo, which is the biggest spirits manufacturer in the world, or Unilever, which makes all the kind of basic personal-care items that we need.

We think for those companies their futures are very predictable and, as a result of that, we think the investment outcome, if you pay a sensible price for those businesses, is likely to be decent.

RYK VAN NIEKERK: Duggan, thank you so much for your time today. That was Duggan Matthews, the chief investment officer at Marriott Investment Managers.

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