New research has identified a positive connection between dividend growth and ESG quality.
“Findings suggest that ESG leaders are more likely than ESG laggards to offer attractive levels of dividend growth over the long term, across a range of economic scenarios. Stable dividend growth can offer some mitigation during periods of rising prices,” said Matthew Jennings, investment director at Fidelity.
This should appeal to equity income investors, he added, given they typically look for two things: an attractive yield and potential for dividend growth.
While factors such as a company’s competitive position and end markets matter for dividend growth, a sustainable operating model and a forward-thinking management team are also important, shows the research.
Rewarding higher ratings
On average, companies that Fidelity rates A for sustainability have the highest levels of historical dividend growth, at over 5%. By contrast, those with stocks rated D and E offer the lowest average levels of growth.
The trend is not entirely linear, noted Fidelity. because the smaller sample for E-rated stocks allows for individual companies to skew the median more than in other ratings groups.
Nonetheless, there is a clear relationship. Good management of environmental and social risks (and opportunities) tends to help companies avoid higher regulatory costs, litigation, brand erosion and stranded assets, added Jennings.
“Strong governance, meanwhile, reduces the risks associated with over-leveraged balance sheets or risky, value destroying merger and acquisitions. This protects profits and allows them to be paid out to shareholders as dividends.”.
In addition, high quality ESG businesses should be able to maintain dividends at more sustainable levels and offer better potential dividend growth over time.
“Our ESG ratings can help identify companies with strong ESG characteristics. Tilting portfolios towards this type of firm can help maintain the purchasing power of equity income portfolios, which could prove useful if inflation remains elevated as economies reopen,” said Jennings.
Selective over sustainability
However, companies in sectors with structural sustainability issues – whether well managed or not – may face weaker dividend growth, according to the research.
For example, oil majors Shell and BP both significantly reduced dividend distributions last year to fund the transition to lower carbon assets. Fidelity believes other energy companies may follow suit in the face of growing calls to increase investment in renewables.
By contrast, said the fund house, utilities with renewable energy operations are benefiting from regulatory and investment tailwinds.
“Given their superior dividend growth prospects, one might expect stocks rated highly for sustainability to trade at significantly lower dividend yields. Encouragingly for income investors, this does not seem to be the case,” explained Jennings.
The difference in yield between the highest and lowest ESG-rated stocks is modest, and certainly manageable within the context of a broad investment universe such as global equities. Some ESG leaders even offer yields that match or exceed those of lower-rated stocks, he added.