Dividend growth funds hold their own in an era of payout cuts and suspensions

  • By Lawrence C. Strauss,
  • Barron's
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Dividend growth funds have outperformed the broader market during the coronavirus crisis—a seemingly counterintuitive performance as a number of high-profile U.S. companies have cut or suspended their payouts.

Take the Vanguard Dividend Growth fund (VDIGX), which is down about 13% since the S&P 500 peaked on Feb. 19, about two percentage points ahead of the broader market’s performance. The fund reopened to new investors this past August after having been shut since July 2016.

“When a company is in a position to, at a minimum, maintain its dividend and perhaps even grow it, that becomes a very powerful value proposition to equity investors,” says Donald Kilbride, the longtime manager of the Vanguard Dividend Growth Fund.

In normal times, he says, the hint of a company cutting or freezing its dividend would be “a reason to sell a stock if we thought that was going to happen, but we want to be a little bit more open-minded on those decisions.”

As of March 31, the portfolio’s top holdings included McDonald’s (MCD) and Johnson & Johnson (JNJ). Its largest sector weighting at that time was health care, followed by industrials and consumer staples. The fund has a strong long-term performance, with its 15-year annual return of 9.4% beating nearly all of its Morningstar (MORN) peers.

Johnson & Johnson in mid-April declared a 6% quarterly dividend increase, one of a handful of companies to buck the cut-or-suspend trend during the pandemic crisis.

Dividend-oriented stock funds often fall into one of two buckets: those that emphasize higher-yielding stocks and those that prefer lower-yielding holdings with better dividend growth.

“If you are going to be in a dividend strategy, a dividend-growth strategy is probably a safer place to be right now and should be for the foreseeable future,” says Dan Sotiroff, a passive-strategies analyst at Morningstar.

Those companies with better dividend growth and lower yields, Sotiroff says, tend to have more stable businesses and cash flows—and they can “weather market downturns much better than the broader market.”

The performance of another fund that emphasizes such companies— T. Rowe Price Dividend Growth fund (PRDGX)—is about even with that of the S&P 500 since Feb. 19. Its performance illustrates both the strength of growing dividends as well as the impact of companies that are cutting payouts amid the pandemic.

Technology and health care were the fund’s two biggest sector weightings as of March 31, accounting for about one-third of its assets. Top holdings included Microsoft (MSFT), Apple (AAPL), and Becton Dickinson (BDX). Becton on April 28 declared a quarterly dividend of 79 cents a share, in line with its previous disbursement. Microsoft and Apple, with their strong balance sheets, are expected to at least maintain their dividends.

“The two largest dividend-paying sectors, technology and financials, have held firm and are well capitalized with low payout ratios,” says Tom Huber , the longtime manager of the fund. He added, though, that the banks “are more vulnerable the longer and deeper” the pandemic and its fallout last.

As of Friday, five of the fund’s holdings have either cut or suspended their dividends recently, Huber says. Holdings he’s added to recently include Marriott International (MAR) and Hilton Worldwide Holdings (HLT), both of which have suspended their dividends amid the pandemic.

Indeed, says Jeremy Schwartz, global head of research at WisdomTree Asset Management, “the sector impact is clearly the dominant story across all the markets.”

He points out that technology and health care have fared much better than more cyclical sectors such as energy during the crisis.

Market-cap weighting is another important factor to consider in these funds. The WisdomTree U.S. Dividend Index has about 1,370 components. It’s seen about a 2% decline in the dividends paid out since late last year. But the drop among large-cap stocks in that index has been 0.7%, compared with a 9% decline for midcap companies and nearly 12% for small-caps, he says.

For example, the WisdomTree U.S. LargeCap Dividend exchange-traded fund (DLN), which is down about 17% since the market reached its all-time high in February, mostly holds large-cap names. But the WisdomTree U.S. MidCap Dividend ETF (DON) is off 30% over that time.

The WisdomTree US Quality Dividend Growth ETF (DGRW), which is down about 13% since Feb. 19, has some 280 holdings culled from the company’s much larger U.S. dividend index. The fund, mostly made up of large-cap companies, selects holdings based in part on expected long-term earnings growth while still weighting firms by total dividends.

The quality dividend ETF’s top holdings include Verizon Communications (VZ) and Procter & Gamble (PG), which announced a 6% quarterly dividend increase on April 14.

One possible concern for these dividend-growth funds is that their universe of potential stocks will shrink given all of the companies cutting and freezing dividends.

But Vanguard’s Kilbride points out that prices have been knocked down, creating more stocks to look at. “We don’t have a playbook for this,” he adds. “We don’t necessarily sell something where we see a deceleration or slowdown in the dividend, but we want to understand the underlying reasons.”

And Huber expects investors will be forgiving as well. “The search for yield will be alive and well on the other side of this given the rate environment,” he says. “Investor focus will eventually move from ‘How do I preserve my capital?’ to ‘Where can I earn a decent return?’ Healthy, safe, and growing dividends will be extremely valuable.”

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