Dividends are so yesterday. As investors zero in on companies that can manage to grow in a pandemic, money migrates to Silicon Valley. There a disruption-driven company declaring its first dividend is seen as a symbol of surrender and declining growth prospects.

That’s all fine and well, unless you are a financial advisor’s retiree client who thought her portfolio would produce enough capital to fund her lifestyle. Compounding this dilemma is the reality that stock and bond prices are at record levels so they throw off chintzy income.

For individuals left to their own devices, the problem can be dangerous. “If people are going to invest in stocks for the dividends because bond yields are really low, then they did it even though they really wanted to invest in bonds but felt they didn’t have a choice,” says Chris Cordaro, CIO of Regent Atlantic.

A decade of quantitative easing followed by the last year of Modern Monetary Theory has upset traditional principles of finance. When Loomis Sayles Vice Chairman Dan Fuss surveys the landscape of income-producing assets, he sees “distortions in the relationships between long-term bonds, high-yield bonds and yield-oriented stocks.”

In his view, the junk bond market has started to exhibit “funny” patterns of behavior that give him cause for concern. That’s why Fuss, an award-winning bond investor who once managed Yale’s endowment, thinks dividend-paying stocks probably are more attractive, even if many are hardly a bargain.

Growth Vs. Yield
Like every other financial asset, many dividend-paying stocks are expensive. Valuations are “stretched by many metrics,” says Michael Barclay, senior portfolio at Columbia Threadneedle.

Most managers of equity income funds interviewed for this article favor the dividend growth style over pure income plays. That’s partly because investors too narrowly focused on income can head toward value traps, says Tony DeSpirito, manager of BlackRock’s Equity Dividend Fund.

Value traps come with a number of red flags, according to DeSpirito: when a company has dividend payout ratios too high to sustain; if it has high debt levels that can pose refinancing challenges; and if it is a low-quality business with poor returns on invested capital. As investors desperately sought income over the last decade, tobacco companies “got way overvalued.”

One of the biggest value traps in many equity income funds five years ago was General Electric. A year before its stock got crushed in 2017, Michael Barclay bailed out. “In September 2016, the cash flow from its power generation business collapsed and we couldn’t see it recovering,” he recalls.

Other aspects of its business, notably GE Finance, looked like a Rubik’s Cube. “It was very hard to analyze,” Barclay says. That always left him “skeptical” about the conglomerate’s huge, opaque financial arm. More recently, cash flow concerns prompted Columbia Threadneedle to also unload ExxonMobil, another once-proud giant now facing serious questions about its generous 6.9% dividend.

Dividend cuts are usually a death knell for companies, but things have played out somewhat differently during the pandemic. Confronted with a lack of clarity about its business last spring, Estée Lauder eliminated its payout for a single quarter and then reinstated it.

Few companies found themselves at the epicenter of the lockdown more than Disney. Its theme parks, cinema and ESPN operations were all on hold. So it eliminated its dividend to invest in its streaming business, a unit that has posted outsized subscriber gains. Disney’s stock has taken off as investors see this as a reopening play. “Disney’s business isn’t permanently impaired,” notes David Park, manager of the Nuveen Santa Barbara Dividend Growth Fund.

Park’s fund has a mandate to provide exposure to all sectors, but like many equity income managers he leans toward growth stocks. “It’s a great leading indicator,” he says. “Over the long term, dividend growers outperform.”

The income investors will get, however, depends on when they purchased a stock. When Apple first started paying a dividend, its yield was about 2.0%, Park notes. Today, the stock has appreciated so much that the yield is a paltry 0.6%.

In the sluggish economy of the last two decades, companies that can grow “get a premium,” explains George Patterson, chief investment officer of PGIM’s QMA unit. But “it’s gotten a little crazy. People are paying for earnings five or 10 years out [in the future]. Sometimes people are just paying for a hope and a dream.”

Equity income funds’ focus on growth is understandable in this environment. Many managers like the tech sector because companies have low payout ratios and strong balance sheets. That allows them to raise the dividends at a high single-digit rate or even at a pace in the low double digits. Over an extended time period, dividends that were anemic when the stock was purchased can throw off significant income.

But Patterson, a quant with a Ph.D. in physics, maintains that dividends are a more relevant metric in the value space. Except for utilities, many of these industries, like energy, financial, real estate and industrials, tend to be more cyclical, so dividend sustainability is critical. In 1999, Fortune named GE’s chief executive officer Jack Welch the “manager of the century.” The reasoning was that he appeared to take a cyclical industrial company and transform it into a business with more stable, recurring revenue streams. By 2017, most business analysts realized that was a mirage.

Look Abroad
If a client is really interested in income, they might be advised to look outside the U.S. That comes with its own set of issues.

Most foreign stocks haven’t appreciated the way their American counterparts have, so dividend yields abroad are close to their post-financial crisis levels. “Europe has not been growing as fast as the U.S.,” Patterson notes. And “dividends in emerging markets can be irregular.”

Still, contrarians can find value abroad. “MSCI high-dividend stocks are two standard deviations cheaper than MSCI growth stocks,” says Phil Camporeale, portfolio manager of multi-asset solutions at J.P. Morgan Asset Management. “That relationship has never been cheaper in this century because stay-at-home stocks have done so well.”

Camporeale isn’t fazed by the prospect of rising interest rates. “In 2013 to 2015, high-dividend stocks were expensive,” he says. That was when the malaise of the Great Recession finally lifted, interest rates started to rise and the bond market threw its taper tantrum. Conditions today are very different.

As markets transition to a post-pandemic world, other attributes may become more important. The Darwinian business climate of the last decade could return. At that point, Fuss thinks factors like a company’s balance sheet, market share and degree of industry dominance, coupled with the specific industry’s growth prospects, are likely to decide who the winners are.