It was, in many respects, the golden age of dividend investing. And it has likely come to an end.
After the Great Recession of 2008, income-producing stocks benefited from an almost perfect confluence: Fixed-income yields were at generational lows (and would stay there for many years), while corporate profit margins and cash flows were rising at a rapid pace, leading to robust annualized dividend growth for many stocks in the S&P 500. And the stocks offering the strongest dividend yields produced impressive multiyear capital gains.
But the perfect confluence has become a perfect storm. The U.S. Federal Reserve has signaled plans to hike interest rates several times per year, corporate cash-flow growth has sharply slowed, and the major market indexes are no longer providing the strong annual returns they once did.
Time to shed exposure to dividend-paying stocks? Not necessarily. But the best strategy for the next few years won’t look like the strategy you’ve been pursuing. More to the point, you can still benefit from these income producers, but you’ll need to be a lot more selective.
End Of An Era
Back in the dark days of 2008 and 2009, companies slashed their spending on dividends, share buybacks and capital investments in order to save cash for a potentially prolonged recession. When the economy rebounded in subsequent years, few companies were inclined to renew investments in factories and equipment, preferring instead to spend cash flow on shareholder perks like buybacks and dividends.
According to Standard & Poor’s (S&P), the average dividend-paying company in the S&P 500 raised its dividend by 26% in 2011, and by an average of 19% over the next three years. It was easy for firms to be generous. Net profit margins, which had averaged 6.3% since 1960 according to the Bureau of Economic Analysis, expanded to above 10% by early 2015. That’s the highest level on record.
But profit margin growth has stalled out in recent quarters, as has dividend growth. The average dividend rose 13% last year. It’s up less, around 10%, thus far in 2016, and looks set to slow further as corporate boards (which set dividend policy) wrestle with an uncertain economic environment.
“Issues like the upcoming political election and the slowing economy in China are a key concern these days when dividend policies are considered,” says Howard Silverblatt, the S&P Dow Jones senior index analyst. FactSet Research’s Andrew Birstingl looked at bottom-up analysts’ forecasts and sees projections of 5.5% dividend growth over the next 12 months.
That’s still a lot better than the outright dividend cuts that we saw in 2008 and 2009. And there’s no reason to expect a new round of dividend reductions anytime soon. While corporate net profit margins have fallen around a full percentage point from their all-time highs (to a recent 9.4%), they remain well above the historical average. As a result, companies in the S&P 500 continue to dole out more than $400 billion in dividends per year, according to FactSet.
Should we expect the golden era of solid profit margins and robust cash flow to wind down? “A look at the history of margins suggests that secular shifts in underlying margin trends can last for decades,” wrote Merrill Lynch equity strategist Dan Suzuki in a note to clients.