Interactive Investor

High yields often end in tears. Here’s how we find income winners

James Dow, manager of Baillie Gifford Responsible Global Equity Income, explains why he focuses on dividend growth and is happy to own low-yielding shares, why he owns Microsoft and Apple, but no other big tech names, and more.

29th September 2023 09:34

Kyle Caldwell from interactive investor

In our latest Insider Interview, Kyle Caldwell sits down with James Dow, fund manager of Baillie Gifford Responsible Global Equity Income. Dow explains why he focuses on dividend growth and is happy to own low-yielding shares. He also makes the case for equity income amid greater competition from bonds and cash, explains why he owns Microsoft and Apple, but none of the other big tech names, and runs through a key theme for the fund: the green energy transition.

Baillie Gifford Responsible Global Equity Income is one of interactive investor’s ACE 40 sustainable investment ideas.

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to the latest in our Insider Interview video series. Today, I'm joined by James Dow, manager of the Baillie Gifford Responsible Global Equity Income fund. James, thanks for your time today.

James Dow, manager of the Baillie Gifford Responsible Global Equity fund: Thank you for inviting me.

Kyle Caldwell: Income funds have different approaches. Some target high-yielding dividend shares, while others focus more on dividend growth and are less concerned about what the yield is today. Your fund falls into the latter camp. So, could you explain why you focus much more on dividend growth?

James Dow: What it boils down to is the results we believe it will deliver for clients in the long term. Our view is that if you focus on dividend growth rather than dividend yield, you end up with more income over the long term, better capital growth over the long term, and you get a much more resilient outcome.

So, the challenge with the high-yield stocks is that typically they are coming from businesses which are ex-growth. They're really struggling to go anywhere. Tobacco, oil, BT Group (LSE:BT.A). They're very mature, plodding businesses, and often they can be quite risky. They might have geared up with a lot of debt. They can be quite deeply cyclical. And if you're an income investor, you've got to really mind your eye. The yield looks attractive today but think about your holding over several years. Often it ends in tears, to be honest.

So, our view is that you're much better off for the long term sacrificing a bit of yield today, coming back down the yield spectrum and focusing on those companies where you really believe there's good growth in profits and dividends over time. So, a classic example that we've owned for years is Microsoft Corp (NASDAQ:MSFT). It's a company that has never had a dividend yield look particularly high or attractive, but it's definitely been a great dividend growth stock. It's well managed, [has] cloud opportunities, [and is] now into AI, [and] throws off loads of cash.

If you look back over time as an income investor, what do you get from Microsoft in the past decade, say, compared with some of those high yielders? I mean, there's no comparison. You've got more income over time. You've got much better capital growth, whereas the others have gone sideways, and it's been a lot more resilient. You haven't had to worry. We talk a lot about our clients, about income clients, in particular. They want to go to sleep at night. They don't want to think, ‘Oh, my portfolio. Is that thing going to blow up and I'll wake up tomorrow morning and there's no dividend?’ You're much better off for long-term outcomes, for resilience, in our view, by focusing on dividend growth companies.

Kyle Caldwell: So, what would your response be to an income seeker who's looking at the fund today? It has a yield of 2% and other funds have higher yields. How would you convince them to back your strategy?

James Dow: I think we'd say that when you're looking for income, ask yourself where you generate that income. Do you purely generate it off dividends or cash interest, or something like that? Or, and I think this is what most income investors do, do you sometimes drawdown capital to be able to fund income? Do you spend some of that capital growth that you've got in your portfolio and say, well, look, it's grown by that. I can spend that amount on net, and I'm still at zero.

Our experience is that most income-seeking investors do a blend of some income generation, but they're happy to spend capital growth as well. So, what I say to investors like that is, if that's what you're prepared to do, which would you rather have? Would you rather have a 5% yielder, let's say, which is kind of going nowhere, or would you rather have something with a 2% or 3% yield? But you might be getting 6% or 7% capital growth, maybe even higher. If you think of the totality of the return you're getting, you're going to be much better off, even as an income client going for that lower yield that's growing. So that would be the mindset that I would advise people to take when they're seeking income.

​​​​​​​Kyle Caldwell: For the first time in a long time, equity income strategies now face greater competition from other assets such as cash and bonds, which have seen their income increase due to the rises that we've seen in interest rates since the end of 2021. How would you make the case, then, for global equity income versus cash and bonds?

James Dow: Right. So, I think a key thing to think about here is inflation. So, yes, cash rates have gone up, but why have cash rates gone up? Well, they've gone up because they are having to compensate investors for higher rates of inflation. We're probably, in the UK, looking at maybe 6%, 5% on average, something like that this year. They've obviously been higher.

So, yes, you could put your money into cash, and let's say you earn 4%-5%, but, of course, your spending power might, at best, have remained flat, might even have come down a little bit with inflation. So, are you growing your savings? Are you growing your future spending power? The advantage of investing in equity income is that yes, your yield might be a bit lower today, but if we do our job right, we are going to be delivering capital growth to you over time. Companies that are growing their earnings, growing their share prices.

So, for an inflation environment, you're much better off owning something with a bit of a lower yield, but you're getting that capital growth. We aspire to own companies that can grow their earnings 10% for a decade. If that came through in share prices, you're getting your 10% and, let's say, a 2-3% yield. You're beating inflation. You are increasing your spending power. You are growing your savings pot. So, although it looks optically more attractive to go into cash, think about the long term. Think about inflation. Our view would be that equity income is a much more compelling place to be.

​​​​​​​Kyle Caldwell: And would you apply the same arguments to bonds as you've just made for cash?

James Dow: Yes. Bonds have the challenge that they are a nominal asset. They're not going to turn around and pay you a higher coupon and your capital is going to be eroded by inflation over time. So, again, it looks more attractive in year one, but think about inflation. Think about the long-term outcomes. Our advice would be for a long-term saver investor, for someone with a long retirement, equity income is going to be a better place for you to be, most likely.

​​​​​​​Kyle Caldwell: I wanted to next ask you about one of the hot areas of the market so far in 2023, which is the strong performance of some of the US technology companies. In your top 10 holdings, you've got Microsoft and you've got Apple (NASDAQ:AAPL). Do you own any of the other big US names?

James Dow: No, we don't. You're right, we own Microsoft and Apple and they're quite sizeable positions for us. But, of those other, sort of high-profile names, no, and it’s for a mix of reasons really. Some of them are to do with responsible behaviours and ESG risks. So, for example, Facebook [Meta Platforms (NASDAQ:META)], I don't think realistically it is one that would fit with us because of some of the challenges that come with its business model.

And then there are other companies where our view would be that there's a bit of a question about the durability of their business model on a 10-year view. They have a great time now, but there might be questions on them further out. Others simply don't pay a dividend, and we're believers that dividends are fantastic in terms of enhancing your returns and delivering you some of that income.

So, our preference is definitely for both Microsoft and Apple. We think they're both fantastically well-run companies. They still have a lot of growth to go ahead of them. [They’re] cash-generative and committed to resilient dividends. I was visiting Apple in California last year, and when you can see on site what it's capable of and what a great company it is, my view is that it is a much better fit for our clients in the long term than some of those other ones.

​​​​​​​Kyle Caldwell: And, of course, a key driver of those share price gains for those US technology companies so far this year has been the excitement around the potential of artificial intelligence. What are your thoughts on artificial intelligence as a theme?

James Dow: Well, it's an interesting one because, over the years there's a lot of exciting new technologies that have [emerged] and they don't always last. 3D printing is turning out to be a bit more of a niche than perhaps some people thought. [There’s also been] blockchain and cryptocurrencies. So, the initial question for us is, is this real? Is this going to last? Is this durable? And our view, in the case of artificial intelligence, is that there's a very good chance of it. It is genuinely interesting.

One thing I look at is who is endorsing the technology. So, let's take cryptocurrency. A lot of the endorsers of that, well, they're now under arrest, frankly, whereas something like AI is endorsed by Bill Gates, who's got a pretty good track record of calling technology, and he says that this is the most transformational technology [he’s] seen in the past 30 years.

So, we're taking it very seriously as an investment opportunity for our clients. And we've got three names in the portfolio that are clearly likely to be beneficiaries of it. One is Microsoft, which you'll know has a very strong position through OpenAI and ChatGPT, and an incredible network to be able to push that out and benefit from that.

Another is Taiwan Semiconductor Manufacturing Co (NYSE:TSM), which is making a lot of the chips that will be required for the high level of computing. Another one nobody talks about; I think it's really interesting. We own a company called Schneider Electric SE (EURONEXT:SU), which is the world leader in electrification kit. If you think about data centres and the computing crunch that needs to happen, that requires a lot of energy. And the people who are the leaders in supplying a lot of the electrification and energy boards around those data centres is this company. Schneider, which again, is in our portfolio. So, we think it's real. We believe we have well-positioned companies to benefit from that trend. And let's see how it how it plays out over time.

​​​​​​​Kyle Caldwell: And are there other themes in the portfolio that you're playing at the moment? 

James Dow: Another one that we're big believers in is the green energy transition. That is going to happen. There's such a confluence of different reasons for that to take off and be a real thing. Part of it is obviously climate regulation changes. Part of is to do with the way technology is evolving and bringing down the cost of some of those renewables and other ways of doing things.

So, lots of different factors coming together to make us think that this, again, is a decade-long tailwind for our clients if we could invest in great companies that are beneficiaries of that. So, examples in the portfolio, include Albemarle (NYSE:ALB), the world's leading lithium producer, we [also] own a wind turbine company and, again, [there are] a few different ways in the portfolio where we see a long-lasting, meaningful tailwind that should drive growth in profits and dividends for our clients.

​​​​​​​Kyle Caldwell: And finally, a question that we ask all fund managers we interview. Do you have skin in the game?

James Dow: Yes, absolutely. It's a portfolio of great growth companies that I genuinely believe in, manage for the long term, [and that have] responsible standards. So absolutely, I have a lot of my savings invested in the Responsible Global Equity Income fund.

​​​​​​​Kyle Caldwell: Thank you for your time today.

James Dow: Pleasure. Thank you for inviting me.

​​​​​​​Kyle Caldwell: That's it for this episode of the Insider Interview series. You can check out the rest of our interviews on our YouTube channel where you can like and subscribe. Hopefully see you again.

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