Responsible Global Equity Income: investor letter Q4 2024

As with any investment, your or your clients’ capital is at risk. Any income is not guaranteed and can fall as well as rise.

This year, subject to the usual final checks and audits, we are anticipating the Responsible Global Equity Income portfolio will pay a distribution approximately 8 per cent higher than last year. This rate of growth will beat inflation in the UK (and most other markets), extending the portfolio’s track record of real growth, and is testament to the solid underlying fundamentals of the holdings in the portfolio.

The portfolio’s total return during the year, i.e. capital growth as well as the income distribution, was solid in absolute sterling terms but lagged exceptionally strong global equity markets. This is uncomfortable, but in some ways to be expected. The emphasis we place on long-term resilience of the portfolio, alongside steady compound growth in earnings and dividends, means the portfolio is likely to lag during periods of market euphoria. The flipside is that we expect the portfolio to hold up better when markets are tougher.

In this letter, after commenting on quarterly and yearly performance and the market backdrop, we will dive into more details of the strong foundations of the portfolio; we will then discuss our US positioning; and comment on the portfolio’s recent transactions, before concluding with our outlook.

The market backdrop

Throughout 2024, the US economy has been slowing down, allowing the US Federal Reserve to start lowering interest rates. After a strong AI-driven rally in equity markets in the first half of the year, markets were hoping this gradual economic slowdown would be limited and inflation would remain subdued.

Then Trump happened. The White House virtually moved to Mar-a-Lago overnight and the President-elect started governing by social media, unleashing animal spirits. This led investors to revise upwards their US growth expectations for 2025 and triggered large inflows from retail clients into US equities. Trump is perceived as pro-business and pro-cyclical, and he propelled US equities to new all-time highs.

Never mind the apparent contradictions of “Trumponomics”, like simultaneously boosting economic growth, raising tariffs and taming inflation whilst driving down the US dollar. Or the potential for a counter-narrative in which higher interest rates slow the US economy whilst its partners retaliate on trade. In 2024, the US equity markets were the standout winner.

The contrast with the rest of the world could not be starker: China is slowing down, two of the largest Euro area economies - France and Germany – are in political limbo, the Middle East is in turmoil and an attempted coup in South Korea has resulted in political paralysis.

China has been the growth engine of the world for the past two decades, but the ten-year Government bond yield has recently fallen below its Japanese equivalent for the first time ever. Some believe we are witnessing a “Japanification” of China, with the real estate bubble bursting leading to what economists call a balance sheet recession. Households, businesses and the local Government are focused on paying back debt, leading to muted investment and consumption. All eyes are now on Xi Jinping and an expected stimulus early 2025.

In Europe, economic growth remains anaemic and the threat of US tariffs and their collateral damage (China exporting more to Europe as the US market closes) has politicians scrambling to devise a response. With the notable exception of Germany, which has kept debt at a relatively low level, other indebted Governments cannot expect to run deficits forever to support the economy and reforms will be necessary to stimulate growth in the next decade.

In summary, the picture is mixed: US economic activity remains robust and is potentially accelerating, growth in Europe remains low and China is slowing down but with a government having room to, and seemingly increasingly likely to, stimulate activity.

Performance

This quarter, in sterling, the portfolio showed slightly negative returns that lagged a benchmark posting exceptional returns (MSCI ACWI up ~6 per cent). The result of the US elections led to a very strong rally in US equities as investors were quick to factor in all the potential positives of Trumponomics (less regulation, lower taxes, higher tariffs, more and cheaper energy) whilst conveniently ignoring some of the potential negatives (retaliation on tariffs, higher inflation and interest rates).

In the quarter, the largest contributor to performance was Taiwanese chipmaker TSMC, the main supplier of NVIDIA’s chips. Its Q3 results showed a 54 per cent increase in earnings vs. the previous year, with little sign of demand weakening for AI chips. The second largest contributor was recently-purchased CME Group, whose shares rallied after it announced a higher special dividend and reported strong underlying results. Networking equipment giant Cisco also boosted performance as investors turned more positive on the potential for AI to raise Cisco’s growth prospects.

On the other side of the ledger, not holding a few technology companies continues to weigh on relative performance, with two of the top five detractors being Tesla and NVIDIA. Of stocks held, Danish pharmaceutical company Novo Nordisk announced disappointing results from a next-generation obesity drug trial at the end of December, leading to a sharp decline in its share price. Whilst this is a setback, it still shows some promising results and keeps Novo Nordisk at the front of the race against obesity, together with Eli Lilly. Even after the decline in its share price, Novo Nordisk remains the top contributor to performance over the past five years. Swedish industrial company Atlas Copco also weighed on performance as recent results showed a slowdown in orders and the company issued cautious guidance.

A quarter is a short period to gauge performance, so we comment below on the full year.

2024: a tale of two markets

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity.” Charles Dickens, A Tale of Two Cities.

The net absolute sterling return delivered by the portfolio was solid at ~5.8 per cent and only slightly below the long-term average return of global equity markets. In relative terms, however, performance over the year was less good, as the portfolio failed to keep up with an exceptionally strong market driven by US equities. The S&P500 returned 28 per cent for the year (in GBP), boosted in the first half by a handful of US companies associated with Artificial Intelligence, and more recently, by sectors expected to thrive under President Trump: for example, banks in anticipation of a bonfire of regulations, and energy companies in anticipation of Trump’s campaign slogan “Drill, Baby, Drill”.

For the portfolio, the underweight positioning in US equities (and its offsetting overweight in European equities) was a strong headwind with the largest drag coming from the underweight exposure to the Magnificent 7 stocks (~36 per cent of the performance gap with the benchmark). We hold two of these companies - Microsoft and Apple - but not owning NVIDIA alone accounted for ~20 per cent of the gap.

Our underweight exposure primarily reflects our investment approach, which is centred on companies that can deliver solid (think 10 per cent per year) earnings growth for very long periods, while generating surplus cash which they return to shareholders principally through dividends. We expect these names to show great resilience across cycles, meaning that even at the trough they can still pay the same dividend. This gives our clients an unusually robust portfolio, which over long periods should deliver market-beating returns. But it also means that when there is a rally in US banks (which only 18 months ago were in danger of insolvency following the collapse of Silicon Valley Bank) or a jump in valuations of automakers such as General Motors (or indeed Tesla) the performance of the portfolio will likely lag behind.

Two companies which fit our approach, among the Magnificent Seven, are Microsoft and Apple. We also invest elsewhere in the technology sector, and these holdings all boosted performance in 2024. A 75 per cent increase in the share price of Taiwanese chip manufacturer TSMC made it the largest contributor to portfolio performance in the year as well as the quarter. It is the dominant manufacturer of high-end chips and a major supplier to NVIDIA and it is still struggling to meet the demand for AI chips. German software company SAP was another contributor as earnings growth accelerated and investors revalue the potential for AI to boost SAP’s profit growth in the next decade. Its software is used by large companies to manage complex operations using vast sets of proprietary data. Using AI to extract useful information offers SAP’s clients the potential to further boost productivity.

Beyond the impact of the Magnificent 7, some holdings have weighed on portfolio returns. French employee benefits company Edenred is facing regulatory uncertainty, which led investors to lower the valuation multiple on earnings that are yet to be affected by possible changes. The decline in Novo Nordisk shares in the last quarter of the year also weighed on relative performance. Brazilian stock-exchange owner B3 published disappointing results and was a drag on performance. All of these are names where we have conviction in the long-term prospects for earnings and dividend growth.

A year is still a relatively short period to gauge performance, so we comment below on the longer-term picture. We believe this is the best way for clients to gauge the success of our efforts to deliver long-term growth of capital and income.

Dividend growth as a signal

We know that dividend growth is a great signal of long-term compounding. Each year we compile the annual results of every holding in the portfolio, clean up the figures to get a clear look at the real picture of a company’s heath and augment this with the longer-term record to evaluate how each investment is performing. When we completed this exercise in the autumn, we were able to see just how the holdings are faring in terms of dividend growth. The answer is that the portfolio’s average dividend growth over the past five years has been approximately 10 per cent per annum (in local currency). This 10 per cent growth has been achieved both on an equal-weighted and income-weighted basis, meaning it is a true representation of the dividend growth being delivered by the portfolio holdings. Reassuringly, it closely aligns with the underlying earnings growth of companies over the same period, a metric we discussed in a previous report, which has also been approximately 10 per cent.

Delivering 10 per cent earnings and dividend growth per annum over extended periods is a remarkable achievement. It requires:

• A well-established franchise in a growing market
• A strong management team who act like owners and focus on the long-term
• A robust balance sheet that supports dividend payments even during challenging times

These characteristics define the long-term compounders we seek, reinforcing our belief in dividend growth as a strong signal. Crucially, the commitment to paying a growing dividend imposes valuable discipline on boards and management teams.

All holdings have contributed to the portfolio’s growth and our 5 per cent cap on income coming from a single company ensures that we do not rely on a small number of high-yielding companies to distribute income.

Looking back, it is the strong operational performance of our holdings which has enabled this steady earnings and dividend growth, which is very reassuring. The fact that other parts of the market have done particularly well this year should not distract from the achievement of our holdings and gives us confidence that, even though the relative performance of the portfolio over the past 12 months has lagged the benchmark, the portfolio continues to do what it is designed to do.

Just as reassuring and consistent is the 5-year compound portfolio return of ~9.7 per cent per annum for the five years to the end of 2024 (Net, in GBP). With no significant change in the portfolio valuation multiple, this return is mostly explained by the earnings growth of the portfolio and is above the long-term average of equities.

In terms of income paid out to unit holders, this has grown at ~5 per cent over the past five years, meeting our objective of beating UK CPI over that period. For our UK Responsible Global Equity Income OEIC, we expect the distribution for the year to be a shade under 3.8 pence. Compared with the distribution of the prior year, this would represent growth of approximately 8 per cent.

In conclusion, the portfolio's consistent dividend growth, coupled with strong earnings performance, underscores the quality of our holdings and our investment approach. While other market segments have experienced exceptional performance, the steady compounding of our portfolio’s earnings and dividends remains a significant achievement for our investors.

US positioning

Splitting the world population as per the MSCI ACWI index would result in a US population of 5.5bn people, or 25x China’s headcount. This illustrates the skew of global equity indices, where US equities have a 68 per cent weight. Other measures highlight that skew: US GDP is ~25 per cent of world’s GDP and US profits are ~55 per cent of world profits.

In view of the seemingly unstoppable rise of US equities, we explain below our benchmark-underweight positioning, show that not is all as it seems, and explain why we won’t rush to fill the gap.

By place of listing, ~45 per cent of the portfolio is invested in US equities. This is much more than we have invested in any other country but is clearly some way below the 68 per cent weighting in the benchmark. There are four main reasons for this gap:

• We seek companies with strong prospects for earnings and dividend growth, regardless of where these companies happen to be listed. Our universe is approx. 6,000 companies globally, of which around 2,000 are US-listed. All else equal we therefore expect about 1/3 of the portfolio to be listed in the US. It would take a leap of faith to believe that 68 per cent of the world’s best compounders are listed in the US.
• US valuations, which for many years were only slightly higher than the rest of the world, have diverged dramatically over the past several years. On a forward-looking Price/Earnings multiple, US equities are trading well into the top decile of their past 20-year range. This has made the US less attractive as a source of income and future capital returns. Often, we will see two good companies listed in Europe and the US, both with a similar mix of business globally, but the US stock will trade on twice the PE multiple and half the dividend yield. We will naturally favour the European name, all else equal.
• US equities tend to use buybacks above dividends to return cash to shareholders. Whilst in theory equal, in practice they are anything but. Buybacks tend to be pro-cyclical (increasing the risk of a company buying back shares on high valuations) and are a lot easier to switch off when times are tough, whereas dividends are far more resilient. 
• We value diversification, which improves resilience. For example, anchoring 68 per cent of the portfolio’s income to a single currency, the US dollar, would introduce a large risk for our income investors. 

These are the reasons behind our underweight positioning in US equities by place of listing. We note this is very different from our exposure to the US economy. How can that be? Well, for example, Nestle is listed in Switzerland, but generates only ~1 per cent of its revenues in that country. Most of European holdings generate significant revenues from the US. Indeed, we know that ~40 per cent of the portfolio’s revenues are generated in the US, only slightly lower than the MSCI ACWI’s 48 per cent.

So, we have no intention of chasing the benchmark and closing the gap. We want to maintain diversification, which is critical to ensure resilience over the long term. We reject the diktat of the index and think it would be imprudent to allocate two-thirds of our clients’ capital to a single market. We note that optimism for US equities amongst retail investors has not been this high since 2009, and this can easily and very swiftly reverse. There is much to like about US companies, but we owe it to our clients to be mindful of all these risks. Markets can be extremely choppy, both up and down, and we are aiming to chart a steadier course.

Transactions 

One new stock entered the portfolio this quarter: US-listed Paychex, one of the largest providers of HR solutions (payroll management and other) for small and medium-sized businesses in the US with a small presence in Europe. For a low fee, their software helps business owners manage a critical function -payroll- as well as things like medical insurance or pension contributions. Founded in 1971, Paychex has been one the main providers in this market since the 1980s and has a very large and diversified set of ~745,000 clients. Key competitive advantages are a deep knowledge of regulations, a powerful distribution network and strong customer support. All of which are difficult to replicate.

We anticipate Paychex's future growth to mirror its past performance, characterized by a gradual increase in its customer base, annual price increases, and successful cross-selling of additional products. While this growth may not be particularly rapid, we expect it to be steady and resilient. Strong cash generation and a commitment to dividends have led to nearly uninterrupted dividend growth since listing in the 1980’s, with only two “flat” years in 2010 and 2011.

The recent share price weakness, driven by concerns about competition from native Cloud companies and worries about a US economic slowdown, provided an attractive entry point for our investment. Our analysis suggests that the economic slowdown is likely already priced in and, following a report by our investigative analyst, we are less concerned about competition.

To fund the Paychex purchase, we divested from Australian-listed Sonic Healthcare, a position we had held since 2014. Our investment thesis was based on the growing volume of lab tests due to an ageing population and the government trend to outsource testing. However, despite the pandemic-induced boost to earnings, Sonic was highlighted earlier this year as one of the few holdings that showed disappointing earnings growth over the past five and ten years. Further analysis has led us to conclude that while test volumes are indeed growing, relentless pressure on fees from healthcare systems and the company's cost inflation are likely to continue weighing on future earnings and dividend growth. Consequently, we do not see it meeting our bar of 10 per cent compounding, and we decided to exit the position.

Stewardship 

A major focus of our analysis recently has been supply chain risk. The landscape of supply chain due diligence is rapidly evolving, driven by a proliferation of regulations, notably within the European Union (EU). With an eye towards ensuring responsible practices by our holdings, we updated our view on how portfolio companies were managing sustainability risks in their supply chains.

Our efforts aimed to evaluate company risk across different sectors and geographies and identify practices that effectively mitigate such risks. We drew heavily on input from supply chain auditing experts with decades of experience. By leveraging their insights, we devised a framework for assessing company practices. This framework recognises the nuances of risk, which vary by industry and locale, while also highlighting the best practices necessary to mitigate these risks. As regulatory pressures mount, companies must meet baseline compliance; but we also wanted to identify some more innovative practices that genuinely address and mitigate systemic issues, such as poverty, that can often lead to labour abuses.

One such example is Nestlé's Cocoa Accelerator program. This market-based approach ties financial incentives to the achievement of sustainable farming practices. It also incentivises a reduction in child labour risk through direct payments for child school enrolment in cocoa-growing communities. By focusing on outcomes rather than compliance, this program seems to be demonstrating success, and it is encouraging to see Nestle expanding the program. This is an example of a company going “above and beyond” simple compliance and gives us confidence that a holding is managing its supply-chain risk effectively.

Overall, our analysis concluded that holdings in the portfolio deemed to be at elevated risk exhibited appropriate commitments and structures to monitor supply chain sustainability practices. However, Cognex and AVI were two holdings where we believe more could be done. We believe this reflects Cognex’s nascent approach to corporate sustainability and in the case of AVI, local market norms. We intend to encourage both to improve practices – indeed, we have previously spoken with Cognex about this matter. L’Oréal and Nestlé, as outlined above, were found to exhibit the most advanced practices, both including commitments to paying the Living Wage, for instance.

Conclusion

As we look forward to the next five years, we feel confident of achieving our clients’ goals for three reasons:

• Dividend growth over the past five years has been and remains strong. The underlying health of the portfolio holdings is therefore good. All our analysis points to this continuing in the future. Not only should this provide good income growth but also good capital growth, because steady growth in cash earnings is the only sustainable way to grow dividends over the long term, and share prices ultimately follow earnings.
• A well-diversified selection of long-term compounders means the portfolio’s future performance should not be hostage to a particular theme, sector or country. Quality growth and resilience remain its key features: the high return on equity allows companies to pay growing dividends and reinvest for growth, whilst the low level of debt provides resilience in challenging times.
• The valuation multiple attached to this stream of resilient cash-flows remains at a modest premium to the index. That index average masks a wide dispersion, however, and the valuation gap between US equities and the rest of the world is at a 20-year high. The combination of relatively high valuation and unbridled enthusiasm for US equities leaves little room for disappointment. The portfolio’s valuation is therefore considerably more attractive.

In the long run, two factors are crucial for delivering attractive investment returns: companies’ fundamental progress in terms of return on capital and earnings growth, and the valuation attached to this anticipated growth. On both the prospects for growth, and for valuation, we are very confident about the portfolio.

Over the next five years, geopolitical tensions, indebted Governments unable to smooth over economic bumps, and a maturing economic cycle will not make for plain sailing investing. The quality and resilience of the holdings provide a robust foundation and should help you sleep well at night.

Source: Revolution, MSCI. Returns have been calculated by reducing the gross return by the highest annual management fee for the composite. 1 year figures are not annualised. *31/12/2018

Past performance is not a guide to future returns.

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