A proper pivot: Time to elevate dividend-focused strategies?
DAN BANASZAK, CFA 01-Apr-2019
The Federal Open Market Committee recently announced it would be neither raising nor cutting interest rates for the balance of 2019. Although the equity market (initially) cheered the news, the reasons for the Fed’s decision were a little less sanguine. The Fed cited sluggish spending and slowing economic activity for its reason to remain “patient.” This is quite the pivot from just a few short quarters ago when Fed was on an aggressive tightening trajectory thanks to growth prospects and robust job creation. Now, the yield curve has inverted (3-month / 10-year), and some pundits are forecasting a global growth slowdown and market turmoil. Should investors be concerned, and how should they position in this current environment?
One possible solution that could allow investors to participate in any continued upside for equities while also managing risk is to focus on high dividend-paying stocks.
The potential benefits have been well-documented. Dividends have been a large contributor to long-term stock returns over time, and with interest rates poised to remain low equity dividends are likely to be an important part of that story. But perhaps even more important are the potential risk-managing attributes of higher dividend-paying stocks. This is illustrated by a substantially higher standard deviation of non-dividend paying stocks versus dividend payers. At the same time, the highest-yielding companies have outperformed those with zero dividend over the long term.
Down capture is the percentage return the constituents in each quartile “captured” versus the S&P 500 Index. A measure of 100% means the quartile's constituents performance exactly the same account as the S&P 500 Index. A down capture of 135% means the zero dividend quartile decreased 35% more than the S&P 500 Index, based on annualized returns. Standard deviation measures historical volatility. Higher standard deviation implies greater volatility.
It appears that incorporating strategies that tilt towards companies with consistent cash flows and pay attractive dividend yields can increase exposure to stocks and sectors with attractive downside risk characteristics. This could be a savvy move in an uncertain environment. However, the manner in which investors allocate to high-dividend equities can make all the difference.
Here are two things to consider before pivoting to high-dividend strategies.
- Scratch below the surface: It’s not as simple as buying the highest-yielding company or finding those companies with the longest history of paying high dividends. After all, dividend yield is just a percentage—a function of stock price—so a company encountering trouble and a stock declining in price might still sport a very attractive yield. A rigid methodology that ignores fundamentals could include companies with artificially high dividends or even those precariously poised to reduce dividends. High yield by itself is not a reliable marker for a quality company.
- Beware unintended consequences: Building a portfolio of high-dividend stocks and weighting it based on market capitalization or dividend yield alone can lead to unintended consequences. Such strategies are likely to be concentrated in their top holdings or overweight in narrow swaths of the economy. Strategies that seek to limit extreme sector exposures and weight securities more evenly can be a more diversified way to access the potential benefits of a high-dividend approach.
In an equities market rife with uncertainties there are viable reasons for tilting an equities portfolio towards high-quality, high-dividend companies. But in doing so, be certain any dividend-focused strategy looks closely at fundamentals and also weights companies evenly across the entire portfolio.