Investors disagree on whether the long-running bull market, which caught its second wind with the so-called Trump bump, will continue to power on. According to surveys, professional investors remain fairly bullish, but many on Main Street don’t trust this particular animal. And with recent economic indicators showing somewhat tepid growth here at home, and geopolitical worries and the shenanigans of the president himself taking a toll, it’s hard to know whether to plan for an imminent pullback or continued interest rate hikes.
Luckily, dividend-paying stocks offer strategies for both scenarios.
Dividend payers have always been popular—the classic image is the retiree who buys household names such as General Electric and Coca-Cola with the intention of “living off” the steady income that dividend payments provide. Moreover, companies that have a history of dividend increases also tend to outperform the broader stock universe. The S&P Dividend Aristocrats Index—which includes only companies that have raised their payments on common shares for at least 25 years—has consistently outperformed the S&P 500, returning 10.7% over 10 years while the latter returned 7.5%. Add to that the phenomenon of certain types of dividend-paying stocks gaining additional appeal as bond proxies in the low-interest-rate environment of recent years, and you’ve got quite a few investors at the party.
This popularity, however, doesn’t mean all dividend-paying stocks are created equally—even those in the “aristocrat” category—and advisors should take care to keep their clients’ expectations in check. Dividends do get cut.
“People buy these stocks for the income, but they need to understand that a dividend is not contractual, it’s not like a bond,” says Scott Davis, lead portfolio manager on the Columbia Dividend Income Fund at Columbia Threadneedle Investments in Boston. “The dividend itself doesn’t create value. What creates value is a corporation with strong cash flow that can return cash to shareholders.”
For example, during the volatile energy market of 2015, Houston-based pipeline giant Kinder Morgan slashed its dividend by 75%. The move, brought on by the severe downturn in the industry after oil prices tanked, was expected by the time it happened but still represented a shocking turnabout for a company that had promised ever-rising payouts to shareholders.
When it comes to dividend investing and market conditions, generally speaking you have two overarching strategies: yield and growth. The former tends to do better in down markets, while the latter outperforms in bull markets, and there are plenty of both active and passive funds to choose from in both categories. Yield investors seek out the companies that pay the highest dividend per share—popular funds of this sort include the Vanguard High Dividend Yield Index Fund and the Fidelity Equity-Income Fund. Growth investors, meanwhile, prefer to see steady dividend increases. The T. Rowe Price Dividend Growth Fund and the ProShares S&P Dividend Aristocrats Fund represent a couple of well-liked options in this category.
The low-interest-rate environment of recent years—even after the Fed’s recent increase, the 10-year Treasury still hovers around 2.20%—has driven many folks into the high-yield category. Retirees especially, who need that steady income, have taken to using high yielding dividend funds as a proxy for bonds. “If you want to keep pace with inflation, you can’t do it with the old school conservative stuff like CDs and bonds; you have to step into equities,” says Robert Laura, president of SYNERGOS Financial Group, a registered fee-based advisor in Michigan. “And there are a lot of people who’ve needed to step in.”
The high-yielding dividend strategy can work well if a recession hits, because many of these companies tend to come from recession-proof industries such as utilities and telecoms. For example, Southern Company pays a 4.45% dividend yield a year, and AT&T pays 5%. (The average large-cap stock pays a 2% dividend yield.)
However, if you’re looking for overall total return, dividend growth companies—generally from sectors like financials, industrials and technology—will outperform high-yield payers. Case in point, tech giant Apple, the largest company by market cap in the world, pays a dividend yield of only 1.72%, but the company has been growing its dividend at a much more significant rate than your typical high yielder. In May, Apple announced a 10.5% increase to its dividend.
Ann Marie Etergino, a financial advisor with RBC Wealth Management in Chevy Chase, Md., says the client who wants high dividends with the idea of living off the income is less concerned about price appreciation and more concerned about cash flow. For these investors, who tend to be heavily invested in certain sectors, she would typically use active strategies because of concerns about concentration risk. And again, there’s expectation management.
“I have one client who wants to live off her income and not her principal,” says Etergino, who caters to a mix of high-net-worth families and nonprofits. “And I’m trying to point out that the most you’re going to generate is 3.5% to 4% because that’s what most high-yielding dividend strategies pay. She thinks she can get 5% to 6%, but you can’t do that prudently and still be growing the assets. … Dividend growers will give you a better total return over time.”
That said, she adds, the dividend growers “are not going to shield you from a market selloff. If you’re worried that the economy’s going to go into a tailspin, buy consumer staples, buy utilities, buy telecommunications.”
Dividend growers tend to do well during bull markets, when the economy is sizzling and inflation is rising. Moreover, these stocks have little correlation with bonds, so they don’t feel the pain of the bond proxies as interest rates increase.
“If you focus on dividend growth and higher quality, then you are more protected from the bond proxy correlation,” says Omar Aguilar, CIO of equities with Charles Schwab Investment Management. “What has happened over the last five years, the higher payout dividend stocks have been highly correlated with the performance of the bond market. Most of the people who have rotated away from fixed income into dividends are the ones who are seeking yield and they tend to be very concentrated in utilities and telecom.”
Of course the question is always: Which direction will the market go? A quick Google search on that will provide you with practically as many opinions as there are dividend funds and ETFs to choose from. Both Aguilar and Laura believe the bull market is in its seventh inning, with room to run, but maybe not as high and as fast as some people think.
While Janet Yellen and her Federal Reserve colleagues raised interest rates at their meeting in June, investors increasingly doubt the central bank’s projection for additional hikes, following soft reports on U.S. employment and inflation. Goldman Sachs has pushed back its forecast for a third rate increase this year to December from September; trading in futures contracts shows odds of a September increase have dropped to just one in four, and investors are now pricing in less than one rate hike in 2018 for the first time since the eve of the U.S. elections in November.
As with any investment strategy, the boring answer to the question above is: You can’t time the market, so it’s best to diversify.
The Schwab U.S. Dividend Equity ETF, for example, has large weightings in consumer staples (24.65%) and information technology (22.36%), with names like Procter & Gamble and Microsoft, so it has both a recessionary and bull market scenario covered.
Moreover, while consistent dividends tend to be associated with blue chip giants, investors should not discount the strategy elsewhere. Dividend-paying mid-cap funds present an interesting investment option, as these securities can offer many of the benefits of investing in large companies—strong cash flows and a stable business model—while offering some of the attractive features of smaller companies as well.
As with their large-cap counterparts, there are a variety of both mid-cap mutual funds and ETFs to choose from. The Sterling Capital Mid Value fund seeks capital appreciation over the long run, generally investing in the value stocks of mid-cap companies, while the T. Rowe Price Mid-Cap Value Fund prefers a long-term strategy of capital growth. Meanwhile, the Thrivent Partner Mid Cap Value fund invests most of its assets in companies with a market capitalization identical to those listed in the Russell Midcap Value Index. And the WisdomTree MidCap Dividend ETF seeks to replicate the WisdomTree MidCap Dividend Index, a benchmark comprising roughly 350 companies with a dividend yield of about 3.4%.
WisdomTree also offers the WisdomTree Emerging Markets Dividend Index which underlies the WisdomTree Emerging Markets High Dividend that screens ETFs for the highest dividend-yielding stocks (the top 30%) available in emerging markets. Of course, emerging markets tend to be volatile—the fund’s return over one year is a staggering 28.3%, but over five years that drops to 1.2%. Other emerging markets dividend ETFs show similar extremes.
Laura says he favors using passive strategies for international stocks he may not be as familiar with or that may have different reporting requirements than their U.S. counterparts. For clients with at least $250,000 of investable assets, he also favors a blend of mutual funds, ETFs and individual securities.
“The human touch of investing is becoming more important than ever,” he says, adding that the ability to communicate to your clients, for example, that they own Diageo and tell the story of how the U.K. liquor distiller, which produces many of the brands commonly found on people’s shelves at home, adds value. “They like to know that stuff. Being able to bring the investments to life is really an important connection advisors can make with clients, instead of: ‘You own these 20 mutual funds like everyone else. Hope it works out for you.’”