Schroders: Exploring Europe's dividend culture

Continental Europe’s equity market has long been a happy hunting ground for income seekers. The dividend culture is very different to that which you see in other markets. It is often supposed than one can invest either for capital growth or for income, but it’s not a binary decision in Europe and there are plenty of opportunities to invest in stocks that can offer both. One of the great things about Europe is that you can obtain yield from almost any sector of the market, so there is a broad range of exposures we can take in order to generate income.

A family affair

Another difference between Europe and other markets is that founding families still hold significant stakes in many European companies and rely on dividends for their own income. Companies where there is an influential shareholder reliant on the dividend stream are more likely to continue to pay out those dividends, even if the firm’s financial metrics are somewhat stretched. Companies without such a shareholder might be more inclined to shore up their finances rather than pay out or raise a dividend. Clearly investors should exercise a degree of caution when investing in such firms but they can be a useful option for those seeking income.

Dividends are not the only means by which firms can return surplus cash to shareholders. Share buybacks are an ever-popular method, although more so in the US than in Europe. This popularity in the US can be traced to several sources, including tax treatment and management incentives. Dividends can be seen as preferable to buybacks for several reasons, not least as a signal of a company’s confidence that it can afford an ongoing commitment to shareholders. Investors also have the option of reinvesting their dividends in the firm if they wish.

Return to shareholders versus reinvestment

Over the past three years, we have noticed a shift in the way companies prioritise their use of cash, away from capital expenditure and merger & acquisitions (M&A) towards dividends and share buybacks. Companies announcing more generous pay-outs to shareholders have typically been rewarded by the market and this has driven a snowball effect, with more companies jumping on the bandwagon.

Whilst that can be helpful in terms of reaching an income target, we believe that a recovery in capital expenditure would be a more meaningful driver of earnings and consequently of share price performance. We therefore look for companies to target a balance between income returns today and investing in the company for tomorrow's returns. There are indications that M&A is starting to pick up in Europe and capital investment should follow.

Traditional income options have lost their appeal

We said above that investors can find income in virtually any segment of the European stockmarket. However, in years gone by, income investors might not have considered equities at all but would typically have left their capital in bond or money market funds. That is not an option in today’s world of low interest rates and low bond yields. The dividend yields offered by European equities currently far exceed the returns available from bonds or money markets. Investors seeking income now have little alternative but to turn to equities.

Even within equities, the best income opportunities currently may not lie in the most obvious places. Classic, ‘safe’ income stocks such as food groups have in recent years become expensive as investors sought out alternative sources of income to bonds. Many such companies are also enjoying high levels of profitability, begging the question as to whether there is scope for further profit or share price improvement, particularly as investors may move out of these stocks as bond yields rise. Stocks that are likely to benefit from rising bond yields – such as insurers – may be a more attractive option. Meanwhile, in contrast to the ‘safe’ income stocks, much of the European equities space is currently experiencing depressed profits, implying high potential for recovery and the possibility of raising dividends as profit growth comes through. As a result, we favour more cyclical opportunities, preferring stocks that can benefit from an improving economic picture in Europe.