Disruptive Innovations and Tax Reform Impact on Shareholder Yield
Although much of the developed world is in the latter stages of an expansionary cycle, global economic growth continues to trend upward. Technological progress and elements of the recently passed U.S. tax bill may provide additional catalysts for higher earnings, free cash flow growth, and stronger equity returns. While the outlook for equities remains positive, at current levels, we believe many investors are underestimating the potential for meaningful increases in dividend payout ratios and share buybacks that can be best captured through a shareholder yield approach.
To gain perspective, we spoke with William Priest, CFA, who serves as CEO, Co-CIO, and Portfolio Manager at Epoch Investment Partners (“Epoch”). Epoch manages over $48 billion in equities and serves as a subadvisor for multiple mutual funds available through New York Life/MainStay Investments.
A Rare, Synchronized Global Recovery
Global economic growth has provided a robust backdrop, supportive of rising profits in the coming quarters. In fact, the variability in gross domestic product (GDP) growth across countries is at its lowest level in decades. Over the long run, however, Epoch believes the global economy could face several headwinds, including the challenges of excessive debt, low productivity, and unfavorable demographics. This may trigger bouts of volatility, which can be mitigated by focusing on quality companies with sustainable business models and a history of free cash flow growth.
Variability in GDP Growth across Countries – Lowest Levels in 50+ Years
Sources: Epoch Investment Partners, Bank of America Merrill Lynch. Note: Standard deviation in annual GDP growth across 45 countries. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
The Benefits of a Capital-Light Environment Surrounded by New Technologies
According to Epoch, the impact of disruptive technologies (e-commerce, robotics, and automation) is affecting every sector of the economy, not just information technology. These technological advances have suppressed wage and price inflation to lower levels than what is experienced in a typical economic cycle. This deflationary influence of technology may persist for several years. With the prospects of low inflation, major central banks may pursue a more gradual rate hike trajectory, thus potentially keeping equity valuation multiples at elevated levels for an extended period.
The combined substitution of technology for labor and assets means that companies do not have to keep the same level of capital in their businesses. From a corporate financial perspective, this is a positive benefit for all three components of return on equity (ROE): profit margins, asset utilization, and leverage. Epoch believes the improvement in ROE has the potential to drive sustained earnings, free cash flow, and dividend growth. This capital-light environment is ideal for shareholder yield strategies that focus on the financial metrics of free cash flow and capital allocation policies that extend beyond dividend payments.
Improving Profitability and ROE Can Support Higher Free Cash Flow Growth
Tax Reform: A Boost for Rising Foreign Direct Investment?
The U.S. tax bill recently signed into law has positive elements that make the U.S. corporate tax system more competitive by international standards. For example, it lowers corporate tax rates from 35% to 21% and adds full expensing of capital investments, while moving towards a territorial tax system for corporations. Lower tax rates also incentivize foreign companies to establish business operations and manufacturing facilities inside the U.S., commonly referred to as Foreign Direct Investment (FDI). FDI has the potential to increase employment, economic activity, and capital spending. The tax bill is also beneficial for U.S. firms accustomed to paying a higher tax rate and should be accretive to future earnings and free cash flow generation.
The combined effect of disruptive innovations and tax reform has different implications for companies and the economic sectors that they operate in. Consequently, Epoch believes it is critically important to conduct intensive, fundamental analysis and favor quality firms with a history of generating sustainable free cash flow. Epoch believes companies that are strong stewards of capital are the most probable winners.
How Will Tax Reform Impact the Markets and the Economy?Watch the video now.
The information contained herein is general in nature and is provided solely for educational and informational purposes. New York Life does not provide legal, accounting, or tax advice. You should obtain advice specific to your circumstances from your own legal, accounting, and tax advisors. Dividends fluctuate and are subject to change. There is no guarantee they will continue to be paid. While dividends may cushion returns in down markets, investments are still subject to loss of principal amount invested.
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Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
Actively managed strategies employ portfolio managers who decide, within the constraints of a prospectus, how assets are invested. For this service, actively managed strategies typically charge higher fees than unmanaged or passively managed strategies.
Free cash flow is the amount of cash a company is able to generate after making required investments in the existing business, such as for new machinery and to pay for supplies.
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