Mega-growth unicorn stocks have dominated for a decade but times are changing, says fund manager GERVAIS WILLIAMS: Where should investors look next?
Gervais Williams: Investors should take advantage of compounding good and growing dividends
Veteran fund manager Gervais Williams is co-manager of the Diverse Income Trust, and also jointly manages Premier Miton’s UK multicap income and UK smaller companies funds.
Over the last 10 years, quantitative easing has come to dominate global stock market trends.
Creating new money to buy government bonds has boosted bond valuations, and this has dragged up the valuations of almost all other assets with them.
During this time, some of the best returns have often been generated by investing in stocks that grow rapidly.
Extra growth can provide greater potential share price performance each year, which can then be boosted further if valuations increase, courtesy of quantitative easing.
For most of the period, the best performing stocks have often been the stock market unicorns with their mega growth and skyrocketing valuations.
Investors haven’t even needed to worry about which stocks they choose. The NASDAQ Composite Index for example, the home of many US unicorns, has risen more than 20 per cent a year, on average, over the last decade.
That adds up to an increase over five-fold without any need to change your investments.
To put that in context, the FTSE All-Share Index is only up just over 25 per cent over the same period. And even with all the dividend income compounded, a FTSE All-Share Index fund hasn’t even doubled.
Going forward, there are some straws in the wind that the current trend may be starting to run out.
Asset valuations are boosted by ever higher bond valuations, but they are running out of steam.
What is a unicorn stock?
In business jargon, unicorns are privately owned start-up firms with valuations that top $1billion, writes This is Money.
Many of these eventually float on the stock market, where their share prices may soar and they end up being worth many billions.
Yields on bonds set to mature many years from now can’t really go much below zero, and they are already ultra-low.
Alongside this, many market commentators expect inflationary pressures to rise, at least in the short term, which tends to undermine bond valuations as well.
If the value of bonds peaks, then the prices of the most volatile high-performing stocks would tend to be negatively affected.
Which prompts the question, where else could investors wondering how to reposition their Isa portfolio consider investing for the best returns?
We believe the answer lies in taking advantage of compounding good and growing dividends.
These strategies are particularly effective at times when share prices are less buoyant than they might be when corporate taxes or interest rates might be going up.
The key point is that even if share prices don’t go up, investors could still make good returns through collecting the cash pay-outs over time.
In particular, if the cash payments are reinvested, then the reinvested cash also starts to accumulate extra income.
This effect is known as compounding, and over a number of years even seemingly slow incremental change can add up to quite substantial total returns.
As it happens, UK listed companies have a long heritage of paying out cash surpluses each year in dividends.
It is important to recognise that the compounding of equity income stocks only works well when the underlying companies are able to sustain their dividends through setbacks.
Last year, at the start of the global pandemic, many UK quoted income stocks became alarmed that their profitability might be permanently reduced. So numerous UK equity income stocks did cut their dividends quite substantially.
With the benefit of hindsight, we can now see that much of the productive capacity of businesses has been retained through the pandemic, and the global recovery, when it comes, could be quite robust.
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Therefore, for those looking for strategies that work well as the value of bonds peak out, we believe that this could be a good moment to consider investing in strategies that compound good and growing dividend income.
It could be argued that those UK stocks that were vulnerable to dividend cuts have probably already cut them.
Furthermore, if anything, some companies may find they are in a stronger position to resume dividend growth than previously anticipated.
These features are coming together in a UK stock market that has already started outperforming the mainstream US comparatives.
We believe that the ingredients are in place for this new trend to persist.
If economic prospects are a bit more unsettled over the coming years, then one of the advantages of being a company with surplus cash is that it can be used during a recession to acquire additional recovery potential from the receiver.
Better still, the UK stock market includes many younger, small-sized companies that can sometimes find ways to sustain growth even through a recession.
Since many of these are often overlooked, there is real potential to add value through stock selection.
Whilst the prospects for the UK economy may not be very different from others, in contrast, the UK stock market is almost unique.
We believe that the recovery of the UK stock market could be larger and extend over a longer duration than most people expect – a bit like it did before, such as between 1965 to 1985.
Relative outperformance of the FTSE All Share versus the S&P 500