Many pension schemes need the certainty of a regular and sustainable income as their income requirements change over time. They need to ensure that they have the ‘cushion’ of an assured and consistent income stream to avoid having to sell assets at the wrong time in the cycle to meet payout obligations to members. In this context, this article brings together two investment strategies that we employ at Newton to help us drive long-term returns for our clients: dividend income and sustainable investing.

Both approaches share a number of traits, such as emphasising the sustainability of a business and its cash- generation capability. Our sustainable investment strategies allow us to take a view on both the sustainability of a company’s business model and its future prospects, while our dividend- income approach has always been tilted towards seeking out companies that can demonstrate sustainability in terms of the recurring dividend stream they provide to their investors.

We take a three-dimensional view on what ‘sustainability’ looks like within our investment process. First, we look for companies displaying the economic durability in their business models that can support a sustainable level of income over the long term; secondly, we take account of material externalities, by which we mean the consequences of commercial activity which affects other parties without being reflected in a company’s own accounts, such as carbon emissions; and, thirdly, we harness our responsible investment analysts’ research to evaluate the sustainability risks and opportunities of a company in an environmental, social and governance (ESG) context, alongside conventional financial criteria.

The benefits of compounding

One of the best known (and yet most forgotten) truths of equity investing is that the biggest determinant of returns is the dividend income and the growth of the dividend over time, creating a powerful compounding effect over the long term. Within our equity income strategies, we implement a strict yield discipline in pursuit of a superior level of compounded income to the market. For us to buy a stock, it must offer a yield premium over the comparative index, and, if the yield on any stock that we own falls below that of the market, it must be sold.

Equities are often still primarily regarded as being in a portfolio purely to provide capital growth. However, thanks to the power of compounding, and with bottom-up fundamental analysis that seeks to unearth quality companies with strong business models at reasonable valuations, we believe that equities can also be regarded as a reliable and sustainable source of income.

We take a three-dimensional view on what ‘sustainability’ looks like within our investment process.

This is especially true if investors can look through the short-term volatility and view equities as a longer time-horizon asset in the way that alternatives such as infrastructure or private equity are regarded. While capital returns can be volatile, income returns are less so, and, as mentioned above, they are also the key determinant of an equity investor’s long-term returns.

We have always viewed a dividend in two ways: first, as a cash reward for shareholders, and secondly, and more importantly, as a potential indicator of disciplined capital allocation. For cash rewards to be sustainable and able to grow over the long term, capital allocation is crucial. For investors to exploit the power of compounding, a disciplined investment approach is equally crucial. The combination of the two can help to significantly improve the statistical likelihood of generating strong long-term investment returns.

Our sustainable investment approach

We believe looking at ESG factors can help investors pinpoint risks beyond those identified in a company’s financial statements – risks which can have a material impact on a company’s performance and reputation. Analysing these non-financial issues can also provide a valuable window on a company’s culture and emerging risks: in effect, how a company’s managers behave when they believe no one is looking. This forms another layer of risk management alongside the more conventional financial analysis. It can also serve to highlight qualities and opportunities that could be missed in purely quantitative analysis, and provides an additional perspective on how sustainable a company’s cash generation is over the long term.

At Newton, ESG is integrated into the investment process for all of our clients’ assets (and has developed as part of the evolution of our investment approach since our inception in 1978). In this approach, ESG analysis is a key input into the investment decision-making process. However, the ultimate decision about whether to include a security in a portfolio lies with the portfolio manager. This means that we may invest in companies which have a lower relative ESG score, if we believe that the valuation of the stock adequately compensates for the risk posed by its weak ESG profile.

The newest element of our responsible investment approach is what we term ‘sustainable’ investing, and our Sustainable Global Equity Income strategy falls into this category. In our sustainable strategies, we place added emphasis on positive ESG credentials, equal to the financial considerations. We omit companies with attractive financial characteristics, if those characteristics are accompanied by a poor or deteriorating ESG profile, unless we believe that through constructive engagement we can help bring about an improvement in ESG outcomes within a predefined timeframe. Our suite of sustainable investment strategies is increasingly gaining traction as investors demand greater levels of clarity and corporate accountability over ESG issues.

There is a growing belief within society that companies should be about more than simply financial profits, and that there should be evidence of a more sustainable approach to their business models. A cursory glance at the majority of regulatory and legislative changes taking place around the world can confirm the direction of travel. Around us on an almost daily basis, we observe companies affected negatively by consumer boycotts, union action, regulatory fines, huge clean-up costs, expensive lawsuits and damaging press and social media coverage.

All these actions show an increasing expectation of better execution of ESG considerations by companies. However, we believe responsible investing is about a lot more than simply aiming to avoid the potential pitfalls. To our minds, companies which are well aligned with this changing zeitgeist are likely to be in a better position to maintain and grow their dividend payouts over the long term.

Newton’s ‘red lines’

Our sustainable strategies have principles-based ‘red lines’ which help to ensure the poorest-performing companies are not eligible for investment. We will not invest in companies that violate the UN Global Compact’s ten principles that promote responsible corporate citizenship (relating to areas such as corruption, labour standards, human rights and the environment). We also avoid companies with characteristics which make them incompatible with the aim of limiting global warming to 2 degrees Celsius. Finally, we incorporate a tobacco exclusion as we do not view tobacco businesses as compatible with our commitment to sustainable investment.

In addition, the responsible investment team have a power of veto over investing in a particular security, if they believe a company or government is beyond redemption and cannot improve. This is a strong signal of what matters to our sustainable strategies both internally and externally.

By combining our pioneering equity- income and sustainable-investing approaches, we are merging two key strengths of Newton to create what we believe is a compelling investment proposition which should resonate with investors. By harnessing the power of compounding and the insights of enhanced ESG analysis with a focus on long-term sustainability, we believe we can produce attractive income streams in a truly sustainable fashion.

Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.

Important Information

This is a financial promotion. These opinions should not be construed as investment or any other advice and are subject to change. This document is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those countries or sectors. Issued by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorised and regulated by the Financial Conduct Authority, 12 Endeavour Square, London, E20 1JN and is a subsidiary of The Bank of New York Mellon Corporation. Newton Investment Management Limited is registered with the SEC as an investment adviser under the Investment Advisers Act of 1940. Newton’s investment business is described in Form ADV, Part 1 and 2, which can be obtained from the website or obtained upon request.

This material is for Australian wholesale clients only and is not intended for distribution to, nor should it be relied upon by, retail clients. This information has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person. Before making an investment decision you should carefully consider, with or without the assistance of a financial adviser, whether such an investment strategy is appropriate in light of your particular investment needs, objectives and financial circumstances.

This information is made available by Newton Investment Management Limited and BNY Mellon Investment Management Australia Ltd (AFSL 227865). This information is confidential and is only provided to Australian wholesale clients (as that term is defined in section 761G of the Corporations Act 2001 (Cth)). This is not an offering or the solicitation of an offer to purchase an interest in the Newton sustainable strategies or the Newton equity income strategies. This document is for general purposes only and should not be relied upon as financial product advice. This document has been prepared without taking into account the objectives, financial situation or needs of any person. Before making an investment decision an investor should consider the appropriateness of the information in this document having regard to these matters and read the disclosure document relating to a financial product. Investors should also consider obtaining independent advice before making any investment decisions. Investments can go up and down and to the extent that this document contains any past performance information, past performance is not a reliable indicator of the future performance of the relevant investment or any similar investment strategy.

Newton Investment Management Limited is exempt from the requirement to hold an Australian financial services licence in respect of the financial services it provides to wholesale clients in Australia and is authorised and regulated by the Financial Conduct Authority of the UK under UK laws, which differ from Australian laws.

Newton Investment Management Limited (Newton) is authorised and regulated in the UK by the Financial Conduct Authority (FCA), 12 Endeavour Square, London, E20 1JN. Newton is providing financial services to wholesale clients in Australia in reliance on ASIC Corporations (Repeal and Transitional) Instrument 2016/396, a copy of which is on the website of the Australian Securities and Investments Commission, The instrument exempts entities that are authorised and regulated in the UK by the FCA, such as Newton, from the need to hold an Australian financial services license under the Corporations Act 2001 for certain financial services provided to Australian wholesale clients on certain conditions. Financial services provided by Newton are regulated by the FCA under the laws and regulatory requirements of the United Kingdom, which are different to the laws applying in Australia.