While dividends have played an important role in total return for both the Columbia fund and the stock market, their importance varies over different time periods. Since 1930, the S&P 500 has had an average annualized return of 9.6%, with dividends accounting for some 40% of that. But in the bear market of the 1970s dividends made up 72% of the return. On the other hand, in the upward trending markets since 2010 dividends have only accounted for about 17% of total return.
But rising interest rates are casting a looming shadow, since they can harm dividend-paying stocks by making bonds relatively more attractive. For most of 2016, the dividend yield of the S&P 500 exceeded the yield on the 10-year U.S. Treasury. The opposite has been true since the November election, as yields on the government bellwether have risen while the yield for the equity benchmark has fallen.
Cash Flow Leaders
Davis points out that when the stock market dips or meanders, dividends become a more important component of total return. Just as important for the fund, investors flock to higher-quality stocks in tough times. “The long bull market has made a lot of investors complacent, and index investors have gotten used to doing well in bull markets,” he says. “But with market valuations so high, this is a good time to be getting more selective.”
Davis points out that even if interest rates rise, dividend-paying stocks will remain attractive because they can increase their payouts to keep pace with inflation, unlike bonds. “I don’t think a mild increase in interest rates is going to present too much of a problem,” he says.
Earlier this year, a report by Sam Stovall, the chief investment strategist at CFRA, also suggested rising rates were OK—but only if there weren’t too big a gap between stock and bond yields. Since 1953, stocks have fared well behind an advancing bond yield, rising an average of 11% and posting price advances 79% of the time when the 10-year bond yield exceeded the S&P 500. But that only happened when the bond’s yield was less than 1 percentage point higher than the S&P’s, showing how close the two must be. “Even though stocks will eventually slip in price, it won’t likely be due to a shrinking yield, so long as it remains competitive with the 10-year note,” Stovall concluded.
Using the Russell 1000 as its stock universe, the Columbia fund starts the investment process by zeroing in on the top two quintiles of companies with free cash flow, which history shows have the best potential for dividend growth. The screen eliminates companies that have very high dividend yields but will not likely have the financial strength to support and increase them. The 2.68% portfolio yield of the fund (before expenses), higher than the 1.97% yield for the Russell 1000, reflects the managers’ mission to find stocks of financially solid companies with sustainable above-average dividend yields.
The fund holds between 70 and 100 stocks, with a targeted maximum position of 3%. It can deviate from sector allocations, but strays only within set parameters to avoid big benchmark tracking errors. It currently has an underweight stance in information technology, health care and consumer staples, and it’s overweight in financials and consumer staples.