To reach their income goals, many investors have been tempted to buy the highest yielding stocks in their respective regional markets; however, such a strategy may have investors overreaching and overpaying for yield.

In this interview, Brad Kinkelaar, head of PIMCO’s dividend team and portfolio manager on PIMCO’s Dividend and Income Builder Strategy, discusses how a global, flexible approach may provide investors with an attractive yield today, a growing dividend over time and long-term capital appreciation.

Q: Can you describe PIMCO’s Dividend and Income Builder Strategy and its key objectives?
Kinkelaar: PIMCO’s Dividend and Income Builder Strategy, which hit its three-year mark in December 2014, invests in dividend-paying stocks around the world with a focus on providing an above-average yield today and the potential for a growing income stream over time, while also seeking capital appreciation. The strategy is unbounded by geography or benchmark, which gives it the flexibility to access a wide array of interesting dividend opportunities across sectors and countries. Interestingly, dividend cultures vary by region and some do not view earnings growth and dividends as mutually exclusive – they typically demand both, which in turn can have a great influence on a company’s management decisions. As such, the strategy’s global opportunity set provides greater potential for dividend investors, as more attractive dividend-paying companies are often found with a global perspective and may therefore enhance diversification more broadly than a regionally focused portfolio.

While the majority of its portfolio is normally invested in dividend-paying equities, the PIMCO Dividend and Income Builder Strategy can also invest in fixed income securities when we see particularly compelling values.

Q: What is unique about the strategy? What role can it play in a diversified portfolio?
Kinkelaar: Unlike many dividend strategies, which tend to be more defensive in nature and more interest rate sensitive as a result, PIMCO’s Dividend and Income Builder Strategy has the flexibility to play both offense and defense. On the one hand, we can invest in basic value and emerging franchises, i.e., companies with cyclical or secular growth characteristics, respectively. On the other hand, we can invest in more defensive opportunities, such as solid blue-chip companies with recurring streams of revenue, or what we call consistent earners. In our opinion, the flexibility to own a broader range of business types is a major differentiator as we seek to create value over time, preserve investors’ capital and participate in growth at different phases of the economic cycle.

The strategy’s focus on current income, growing dividends and capital appreciation makes it an attractive investment strategy through various market environments. Dividend income is a key component of overall equity returns, and is particularly important as many investors are nearing retirement. We also believe an actively managed portfolio of dividend-paying equities may serve as an attractive source of income growth that could potentially outpace inflation.

Q: How do you seek to generate long-term investment results versus the equity market?
Kinkelaar: As is our investment style, the strategy is a high-conviction portfolio with high active share – an indication that a portfolio meaningfully differs from its benchmark. Sizing positions based on research conviction rather than benchmark weight typically results in high active share, which is an important indicator of the potential for outperformance. It stands to reason that a manager who emphasizes their positions of highest conviction, regardless of benchmark representation, should produce attractive results over the long term if their convictions are well founded. And that is our goal.

Q: How have dividend-paying stocks performed historically? How might they do going forward, particularly in a rising rate environment?
Kinkelaar: It is well known that stocks with higher-than-average yields have outperformed markets over long periods of time. It is less well known, however, that companies that not only have a higher-than-average yield but also have grown their dividends at an attractive rate have significantly outperformed stocks characterized solely by higher yields. Yield and growth are not mutually exclusive, as many people believe; in fact, when you get both, the long-term results can be really attractive (see Figure 1).

 

Recently, the market has favored the highest-yielding stocks over dividend growers, which is typical of a low-rate environment. But if markets lose some momentum going forward, as we expect they will, a dividend growth strategy, such as PIMCO’s Dividend and Income Builder Strategy, is likely to shine. This is important because many stocks with high dividend yields also have lofty valuations and can be more bond-like, and thus convey heightened interest rate risk. We look to build a portfolio with higher dividend yields that benefit from economic growth while attempting to manage the downside risk if yields begin to rise.

Over the coming three to five years, PIMCO’s New Neutral thesis anticipates monetary policymakers will set short-term interest rates at levels below the rates that prevailed before the global financial crisis. And we expect any increases in interest rates, however, to be gradual and, in our view, relatively modest compared to hiking cycles of the past. This is key.

In a normal rising-rate environment, what really matters is why rates are rising. Given activities by global central banks since the financial crisis and low inflation, we think it is a fair assumption that if rates increase, it would be because of economic growth. And given our very conscious decision to be exceptionally careful around bond-like equities – which we anticipate would be those most likely to be negatively affected by an increase in rates – we believe the growth potential embedded in our portfolio should offset any perceived decrease in the value of the dividend streams due to increased rates. In fact, given the composition of its portfolio, we think the strategy is well positioned should rates rise on a gradual path.

Q: What is the strategy’s investment process?
Kinkelaar: Put simply, it is a bottom-up, scenario-driven process that carefully evaluates global risk/reward opportunities. Although the future is by definition uncertain, we spend a significant amount of time trying to understand the range of potential outcomes. If the range of possible and probable outcomes is favorable and we believe the stock is attractively priced, it is a candidate for the strategy.

Becoming part of any of our dividend portfolios, however, involves overcoming some high hurdles: There are more than 2,000 companies globally that we could potentially invest in. We travel the world and meet with hundreds of companies every year. And in a rigorous, repeatable and disciplined process, we create highly detailed and flexible models that stress test different scenarios and sensitivities. Yet, in the end, only about 100 securities make the cut for inclusion across all of our dividend strategies.

Our entire investment process is enhanced by PIMCO’s extensive global resources and macroeconomic insights. For example, we frequently use PIMCO’s proprietary credit research to help us better understand a company’s entire capital structure. At a higher level, PIMCO’s Cyclical and Secular Forums and macroeconomic insights, as well as our participation in PIMCO’s Investment Committee, inform our understanding of how macroeconomic dynamics may affect individual companies over the medium- and longer-term horizons.

Q: Where are you currently finding opportunities, and how is the strategy being positioned for the environment ahead?
Kinkelaar: In broad terms, we prefer pro-cyclical, basic value companies in the consumer discretionary, financials and technology sectors in markets characterized by moderate to strong growth. In regions or markets where the risks are heightened, we have the flexibility to invest in more defensive names in the consumer staples, health care and utilities sectors.

Given low rates, low inflation and moderate expansion in the U.S. and the UK, as well as quantitative easing in Europe and Japan, we believe equities are generally an attractive asset class. And, in a world of low interest rates, equities still may provide investors the opportunity to earn an attractive income stream through dividends that could grow over time. Because we focus on total return, the equities we select for our portfolios must also be attractively valued with the prospect of capital appreciation. We believe dividends are a key element of total equity return and provide valuable insight into a company. They can indicate how a management team thinks about capital allocation, which is one of the most important jobs of a chief executive officer and chief financial officer. In our view, companies that give capital back to shareholders and have a willingness and desire to increase dividends as the company grows earnings will tend to invest in higher-return projects. This can create a virtuous cycle in which a company grows, its dividends grow and total return potential is attractive.

Q: Does PIMCO manage other income-oriented strategies?
Kinkelaar: PIMCO offers a range of income-generating strategies that focus on consistent or growing income across the risk/return spectrum. On one side of the spectrum, there is PIMCO’s Income Strategy, an award-winning multi-sector bond strategy with a 100% allocation to fixed income that is managed by Morningstar award-winning and Citywire AAA-rated PIMCO Group CIO Daniel J. Ivascyn and managing director Alfred Murata. On the other side is PIMCO’s Global Dividend Strategy, a 100% dividend-paying equity strategy managed by myself and portfolio manager Austin Graff, as well as combinations in between: Our Strategic Income Strategy (75% fixed income/ 25% equity) is the newest member of PIMCO’s broad suite of income-generating strategies.

Importantly, each of our income-generating strategies follows the same investment philosophy, and the investment teams work closely together across the spectrum of strategies to find the best opportunities for investors.