Investors are doing well this year by emphasizing high-growth stocks and riskier parts of the market. But dividend-growth stocks may be poised to outperform, benefiting from low valuations and a favorable climate of falling interest rates.
Dividend-growth stocks look cheap, according to Goldman Sachs. Large-cap stocks with expected dividend growth of 10% a year through 2020 trade at 12 times earnings, compared with a P/E ratio of 17 for the S&P 500 (.SPX), which is expected to have dividend growth of 6% on an annualized basis. Stocks in Goldman’s dividend-growth basket yield an average 3.5%, well above the market’s 2% yield.
Dividend growth is considered a stock “factor” or attribute. It can be a proxy for quality since companies with dividend growth tend to have relatively high returns on equity and consistent cash flows. Indeed, in Goldman’s framework, dividend-growth stocks have returns on equity of 24%, well above the market average of 19%.
Dividend growth hasn’t been a strong factor this year. The Dow Jones U.S. Select Dividend Index —a basket of large-cap stocks with yields above their five-year average—has returned 13.3%, trailing the S&P 500’s 16.1% return. About a quarter of the index consists of utilities that are up just 9% this year, on average.
But the interest-rate backdrop for dividend stocks now looks more favorable. The Fed is now expected to leave its benchmark federal-funds rate unchanged or cut slightly it in 2019, a sharp reversal from last fall when the Fed was expected to increase rates. Lower rates push down bond yields, making them less competitive with income-oriented stocks.
Dividend strategies lagged behind the market while the Fed was raising rates, but the new rate landscape “puts them back on the radar,” says Brian Belski, chief investment strategist for BMO Capital Markets. Indeed, the DJ U.S. Select Dividend index produced the strongest returns relative to the S&P 500 when the 10-year Treasury yield was below its one-year average and falling, according to BMO. That has been the case lately, potentially setting up dividend stocks for gains.
Granted, there is a distinction between high-yield and dividend growth. High-yield sectors such as utilities lack much revenue growth, limiting gains in their shares and their ability to increase dividends. Companies with more growth can hike their dividends at a faster clip, and they offer more potential for price gains. The tech sector, for instance, is now fertile ground for dividend growth, led by companies such as Apple (AAPL), Broadcom (AVGO), and Microsoft (MSFT). Other dividend-growth stocks, according to Goldman Sachs, include Starbucks (SBUX), Amgen (AMGN), AbbVie (ABBV), and Omnicom Group (OMC).
The WisdomTree U.S. Quality Dividend Growth (DGRW) exchange-traded fund holds stocks that meet minimum criteria for dividend growth and quality. It holds dividend-stalwarts across a range of industries, including Exxon Mobil (XOM), Microsoft, Procter & Gamble (PG), and Verizon Communications (VZ). It yields 2.1% and has an expense ratio of 0.28%.
The iShares Select Dividend ETF (DVY) tracks the DJ U.S. Select Dividend index. The ETF is only up about 12% this year. But the index’s total returns have edged the S&P 500 over the last decade, gaining an annualized 15.8% versus 15.3% for the market. The ETF yields 3.6% and costs 0.39% in annual expenses.
Granted, dividend-growth probably won’t beat the market consistently. Throughout a full market cycle it is likely to fall behind, and going back 20 years it hasn’t kept pace with the S&P 500 (based on returns for the DJ dividend index). But “at some point the market will soften up,” says Belski. Dividend stocks could pay off when that happens, and investors can at least earn some income while they wait.
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