Want dividend stocks? Look for dividend growth over higher yields

  • By Lawrence C. Strauss,
  • Barron's
  • Investing for Income
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That’s the conclusion of Brian Belski, chief investment strategist at BMO Capital Markets—though he cautions that investors should be discerning about the type of dividend stocks to hold.

“We prefer to focus on stocks that combine dividend growth and yield characteristics,” he wrote in recent note titled “Rising Rates Do Not Derail Dividend Growth.”

“Equity income is an important sleeve of asset allocation, especially given that fixed income is seeing negative real rates of return,” says Belski, who argues that investors don’t pay enough attention to companies with solid, persistent dividend growth.

Higher rates can impede stock performance as other types of securities, notably bonds, become more attractive options. The Utilities Select Sector SPDR ETF (XLU) has returned 1.4% in the past year, versus 8.25% for the S&P 500 (.SPX). Other traditional dividend havens such as consumer staples and real estate investment trusts have also underperformed.

Belski concedes that yields have risen—the 10-year U.S. Treasury’s yield was recently at 3.12%, compared with about 2.4% a year ago—but adds that these movements have also pressured bond prices, challenging total returns. Treasury yields, however, have slipped recently as investors, concerned about the volatility of stocks, tilt further toward safer assets. (Bond prices and yields move in opposite directions.)

In screening for dividend-growth stocks, Belski uses several criteria. He looks for S&P 500 stocks that haven’t had a dividend cut in the past five years, have a dividend yield greater than the benchmark’s, have a free-cash-flow yield that’s above the dividend yield, and have a payout ratio lower than the benchmark’s.

Among the stocks that meet these screening criteria are BlackRock (BLK) , Bank of America (BAC), Union Pacific (UNP), and Delta Air Lines (DAL).

Screening isn’t the only tool Belski uses in overseeing several investment portfolios.

For example, two of the dividend growers he holds in a portfolio for clients— Apple (AAPL) and Microsoft (MSFT)—sport yields of 1.3% and 1.7%, respectively, below the S&P 500’s 2%. Both companies are generating a lot of cash and have been regularly boosting their payouts.

Part of the attraction of dividend growers is that, unlike a fixed-income holding, they can raise their payouts every year above the inflation rate. Also, a company’s ability to regularly raise its dividend often signals underlying strength in its earnings and growth prospects.

Belski points out that a portfolio of dividend growers has outperformed the S&P 500 and a portfolio of higher-yielding stocks during the seven periods since 1990 in which 10-year U.S. Treasury yields have climbed for at least one year. As the table above shows, the dividend growers have an average annual total return of 21.7% over those periods, compared with 11.4% for the higher yielders. The S&P 500 had an average return of 18.6%.

Dividend growth stocks contrast with the higher yielders in terms of sector weightings, at least based on the portfolios put together by Belski to represent each strategy. The dividend growers are much more cyclical, with about half of the portfolio in financial stocks. Utilities account only for 2% of those holdings.

In contrast, utilities account for 16% of the higher-yielding stock portfolio, with real estate holdings making up another 28%.

Belski maintains that U.S. stocks “are in the midst of a secular bull market that has many years of life left.”

That would favor cyclical holdings. But if the economy ends up slowing down or slipping into a recession, defensive names could be more attractive.

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