Why ESG values and income generation shouldn’t be traded off against each other
Duncan Goodwin, Premier Miton Global Sustainable
Optimum Income Fund Manager looks at how traditional ways of generating income come with some associated baggage.
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Everyone has their own reasons to invest. Some just hope to get their money working harder, others want to put money aside for something special down the line. And more people are looking to invest for their retirement.
So many different needs inevitably lead investors to follow different strategies. One of those strategies could be boosting your income, but to us a traditional way of generating income comes with some associated baggage.
What is equity income?
Equity income funds invest in companies that aim to pay a dividend. Companies pay out dividends from profits that they’ve earned, but don’t need to plough back into the business.
A combination of a good dividend yield and some capital growth on top, can add up to an attractive total return over time. Lots of equity income funds have the aim of generating both income and capital growth over time.
Equity income funds can be used within a portfolio to generate cash that the investor can either choose to reinvest back in the fund, or to take as income for themselves.
Sounds good so what are the problems?
The dividend hunting ground could be shrinking
During the Covid pandemic some dividend focused company shares implemented broad based dividend cuts and suspensions due to the uncertainty about their future cashflows. A couple of years down the line now, the dividend recovery has been worryingly uneven, with mining stocks and other cyclical sectors leading the substantial growth in pay-outs.
More fundamental concerns continue to linger, too, such as is some income investing inherently challenged, with the risk of investors backing companies offering high yields rather than hunting sustainable returns? A historical issue for many income funds is that the drive for higher dividends can limit the pool of companies that can be invested in. Inherently, companies with high dividends may have lower growth expectations, and even worse are often in industries that are in structural decline.
Who are the dividend aristocrats?
Large dividends can be paid for a few distinct reasons, one of them could be because a business is mature and generates prodigious amounts of cash but is running out of opportunities to reinvest. Alternatively, the high dividend could be being used by the board of directors to encourage institutional ownership.
A review of the S&P UK High Yield Dividend Aristocrats Index, which is compiled based on the 40 highest dividend-yielding UK companies with increasing or stable dividends for at least 10 consecutive years features oil and gas companies, banks, tobacco, defence technology companies and alcohol distributors.
While these companies can pay dividends because they are cash rich, as a result of being successful in building today’s economy – these are companies that arguably have a negative impact on society today and may not actually be the first choice for investors, if it wasn’t for the dividends that they offer? This may especially be the case if future generations of investors are more likely to be concerned about ESG issues?
Industry 4.0 and dividend generation
We also should question will these companies be at the core of Industry 4.0. Industry 4.0—also called the Fourth Industrial Revolution or 4IR—is the next phase in the digitization of the manufacturing sector, driven by disruptive trends including the rise of data and connectivity, analytics, human-machine interaction, and improvements in robotics.
Going back to dividends, factors such as a company’s competitive position and end markets matter for dividend growth. But a sustainable operating model and a forward-thinking management team are also important.
Good management of environmental and social risks tends to help companies avoid higher regulatory costs, litigation, brand erosion and stranded assets. Strong governance, meanwhile, reduces the risks associated with over-leveraged balance sheets or risky, value destroying M&A. This can protect profits and allows them to be paid out to shareholders as dividends or reflected in their share prices.
ESG values and income generation shouldn’t be traded off against each other
Investors shouldn’t have to trade-off strong stock performance and growth for ESG values. Some of the largest companies have been able to balance ethical, social and environmental responsibilities with profitability perfectly.
Funds that invest in companies that provide social good, like income focused funds, are also often limited in what they can invest in, and performance can be driven as much by the popularity or not of the theme as by the actual company performance.
What if you have a client who wants an ESG based income?
Tobacco companies and oil majors may not be everyone’s cup of tea, but that fundamental identified need for an income remains from your client – what are the options?
The solution may be a fund that:
- Is unrestricted in its ability to invest in companies that offer thematic, structural growth.
- Has a positive societal bias.
- Can be competitive in its generation of income.
Have a look at the Premier Miton Global Sustainable Optimum Income Fund.
Income generation: The objective of the fund is to provide a yield of 7% per annum together with the prospect of capital growth over the long term, being five years or more. Five years is also the minimum recommended period for holding shares in this fund. This does not mean that the fund will achieve the objective over this, or any other, specific time period and there is a risk of loss to the original capital invested. The fund’s target yield is not guaranteed and may change if the assumptions on which the target is calculated change.
Global in nature: The fund offers a portfolio of company shares, selected from any geographical region of the world.
Thematic: The fund focuses on long-term sustainable growth themes which could include health and wellbeing, energy transition and circular economy, amongst others.
ESG and sustainability aligned: The United Nations Sustainable Development Goals are used to provide a globally recognised set of standards with which to align the investments in the fund.
Uses a covered call strategy: Covered call overwriting involves selling a call option on a share that an investor owns. When selling out-the-money call options, the seller retains the potential capital growth up to a certain level (the strike price), but potential growth above that level (over a set period of time) is sold in exchange for an upfront cash payment.
Selling out-of-the-money means the underlying price of the share is below the strike price at the point at which the option is sold – thus the fund still benefits from any share price growth up to the strike price.
In this way, a covered call strategy exchanges some potential share price growth for the certainty of an income payment now.
The final word
Simply put, we offer a fund that aims to provide an income yield today but invests in companies that aim to grow for a better tomorrow.