This is a sponsored article from BNY Mellon Investment Management.

In a world challenged by negative yielding debt, where should investors turn for income? BNY Mellon Investment Management’s Sebastien Brown discusses.

Anyone unsure of the power of dividends in wealth creation should consider historic data from US equity markets. The chart below illustrates how, on a pure capital gains basis, US$1 of equities bought in 1900 would have grown to US$215 by the end of 2011. But if income from those stocks had been reinvested over that time period then that same US$1 would have become US$21,978. In this scenario, dividends and their reinvestment played a crucial role, ultimately accounting for 99% of returns.

Other studies paint a similar picture. The second graph below, which disaggregates the components of total return from the US stock market over 200 years to the end of 2002, underlines how fundamental dividends and their reinvestment can be in creating long term wealth.

In equities, you need to ask how sustainable current multiple expansion is, particularly in the US where equity market valuations keep reaching historic highs. Meanwhile, seemingly rock solid dividend opportunities – think select banks and REITs – are beginning to show early signs of strain. How many ‘zombie’ companies have been kept alive through the life support of QE, coupled with low rates and the demand for yield? How sustainable are retail-linked REITs with high streets decimated by the growth of Alibaba and Amazon?

Nick Clay, Lead Manager of Global Equity Income strategy has the view that high payout ratios are not always as positive as they might appear. Is the company paying for the dividend through strong, sustainable revenues, for instance, or is it funding payouts through debt? For longer-term investors, it’s a crucial question, particularly if the end investor relies on consistent income.

Disciplined capital allocation

Another reason to look beyond the immediate attraction of high or increasing pay-out ratios is that it could point to a business that is in financial distress and the market has caught on to it . If a company has kept its dividend stable but reports lower profit than its previous reporting season it will have a higher pay-out ratio than before – but that does not necessarily mean it is a good investment. This emphasises the need for an active approach (as opposed to passive) when investing for equity income.

Far better, instead, to consider companies with disciplined capital allocation and with management teams with the right incentives that share their profits with shareholders instead of ploughing profits into pie-in-the-sky projects or ill-timed acquisitions.

When entering the income vs growth equities debate, many commentators believe that these two are mutually exclusive features. But as the chart below demonstrates, there is in fact a positive correlation between a company’s pay-out ratio and its subsequent 10-year earnings growth – which suggests that companies with disciplined capital allocation in the form of a reasonable and consistent dividend payment can offer attractive growth opportunity to investors. However, these companies are few and far between, which reinforces the active investment approach embraced by Newton to identify these rare companies. Nick concludes: “If a company generates a lot of profit, but does not require cash-intensive investment in order to improve profitability then there is no reason for it to hold onto that cash. In fact, disciplined allocation of cash might lead to higher profits over the longer term because firms focus on their core business and don’t deviate from what made the company successful in the first place.”

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This is a sponsored article from BNY Mellon Investment Management.