Are dividends doomed?

Of course not, but like just about everything else in the financial markets during the coronavirus-induced turmoil, dividend investing has taken a hit both in terms of performance and on reports of actual and speculated dividend suspensions and cuts.

For starters, the squeeze on interest rates since the Great Recession has caused many yield-seeking investors to flee into the arms of dividend-paying stocks and funds. This bid up the valuations of companies in traditionally stodgy—some would consider “safe”—sectors such as consumer staples, communication services and utilities.

But the ongoing (yet seemingly recovering) market crash has drummed home the point that equity income is just that—“equities.” So when equities plummet, so do most companies that pay hefty dividends. In other words, don’t expect your dividend-paying stocks to provide much of a cushion during a market free fall.

For example, take a look at the performance of some of the leading dividend-focused exchange-traded funds during the past month. As listed by ETFdb.com, the top five products (three from Vanguard, one from State Street and one from iShares) registered one-month declines ranging from 20% to more than 36% as of Wednesday’s market close. The eighth-largest product in this category, the ProShares S&P 500 Dividend Aristocrats ETF (NOBL), which tracks the S&P 500 Dividend Aristocrats Index comprising companies that have grown their dividends for at least 25 consecutive years, had dropped 27.1%.

In comparison, the S&P 500 ETF Trust (SPY) had lost 22.8% during that period.

“Up until this bear market, the markets have worked so well that people have been looking at equity as a replacement for bonds,” says Leo Kelly, CEO of Verdence Capital Advisors, a private wealth advisory and multi-family office firm in Hunt Valley, Md. “And there’s nothing like a bear market to wake up people to the reality of true risk and volatility. And by the way, those are different—risk is the loss of money; volatility is the movement of money.

“I think investors’ attitude toward risk will be reset,” he adds. “It’s a classic bull market mentality to say, ‘I’m an equity-income investor and it’s OK because I’m a long-term player and it’s no different than holding a long-term bond, so I’ll hold my equity and I’ll be fine.’”

But Kelly posits that mindset goes against human nature, especially for income investors who tend to be a bit lower on the risk scale than growth investors.

“So when you see a massive decline in the principal that’s far in excess of the income, the question is do you really have the wherewithal to ride this out?” he says. “Or will you make the classic mistake of turning volatility into risk by selling in a downturn?”

Kelly says the good news about the recent market carnage is that it has flung open the door to investing opportunities in beaten-down dividend-paying stocks.

“We think there will be a V-shaped economic recovery and things will get back to normal,” he says. “So companies with cash will try to maintain their dividends as best as they can, and if you buy these equities at a discount you’ll be rewarded with excess dividends.”

Opportunities In Dividend Land

With “On Sale” tags affixed to many equities right now (though the discounts aren't as steep as they were several days ago), how do investors find the best dividend bargains? Better yet, how should people approach equity income in the first place?

“In order to have a safety cushion, I’d want the payout ratio to be less than 70% so that if the company falls on hard times and their earnings fall by 30%, they still will cover the dividend,” says Sam Stovall, chief investment strategist at investment-research firm CFRA.

He notes that traditional dividend-paying defensive sectors—e.g., consumer staples, communication services and utilities—were risky even before the crisis because they were trading at high absolute and relative price-to-earnings multiples. That said, they’ve held up the best during the downturn. Which means, on a relative basis, their respective current p/e ratios are still trading at a premium to their average p/e ratios over the past 20 years.

Based on current and 20-year average relative p/e ratios, Stovall explains, the biggest discounts are found in the financial, health-care and industrial sectors that have suffered the largest price declines during the past month.

“Those sectors likely to bounce the highest once we get some sort of a recovery will be those that took it on the chin the most,” he says.

Regarding individual names that could be good dividend-oriented investments right now, Stovall ran companies through CFRA’s qualitative STARS system and came up with 20 candidates that, as of last Friday, fit the bill based on their “strong buy” or “buy” ratings, quality rankings in the “A” range, and dividend yields of at least 3% and payout ratios equal to or less than 70%.

That list includes CVS Health, General Mills, Pinnacle West Capital, Tyson Foods and DTE Energy. Other names he mentioned include Ameriprise Financial, State Street and JPMorgan among financials, as well as industrial names such as General Dynamics, Lockheed Martin, Raytheon and United Technologies.

Dividend Cuts

The sudden clampdown on the U.S.—and global—economy caused by COVID-19 has hammered many businesses and their cash flows. In response, a host of companies including Ford Motor Co., Delta Air Lines, Alaska Air Group, Freeport-McMoRan, DCP Midstream Partners, Boeing, Darden Restaurants, Macy’s, Marriott International and Coach parent Tapestry this month announced they’ve suspended or cut their dividends, among other measures to preserve cash. 

David Trainer, CEO of investment-research firm New Constructs LLC, sees more dividend cuts or suspensions coming. “Certainly, companies with limited cash flow for paying dividends could be in some trouble,” he says, noting the energy sector is a prime candidate in this regard.

Indeed, there’s much speculation that blue-blood Dividend Aristocrats such as ExxonMobil and Chevron will eventually have to cut or suspend their dividends. But some observers don’t think that will happen.

“We question whether Exxon would do that because even though it’s paying slightly more than 100% of its earnings in the form of dividends, it has the cash flow to support that dividend,” Stovall says. “And Exxon knows that it has turned off the growth investors, so does it really want to turn off the income investors, too?”

Like with any investment focus, due diligence is the key to finding the best dividend opportunities.

“Whether it’s a dividend stock or any stock, you need to really understand the profitability of the business in order to understand its viability,” Trainer says. “The big takeaway here is that income statements and pro forma earnings numbers are not accurate representations of profitability. Investors need to study the balance sheets and all of the footnotes in the filings to get a complete picture on the profitability of the business. If you don’t do that, you take undue risk. And you might get away with that for long time periods, but in markets like this you don’t.”

Trainer recently screened companies with fairly high dividend yields and negative free cash flow to find those with the riskiest dividends. That list includes Occidental Petroleum, ViacomCBS, Prudential Financial, GlaxoSmithKline, Hewlett Packard Enterprise, Pfizer, MetLife, General Motors, Broadcom and Duke Energy, among many others.

“If their free cash flow was negative over the prior 12 months when the economy was much better than it is today, then they will likely have poor free cash flow in the future,” Trainer says.

He offers that the recently departed bull market enabled investors to take on more risk because they didn’t see the incremental consequence of that added risk.

“You don’t get reward without risk,” Trainer says. “But after recent events, investors will probably be more cautious. That said, it will depend on the duration and severity of this downturn. If the market in the next month or so is back to where it was, people will probably say, ‘What an overreaction,’ and they’ll be right back at it.”