Building a portfolio of dividend-paying stocks may seem easy—just buy the stocks that pay the highest yield, or an exchange-traded fund (ETF) that does that same thing, and voilà, you’re done. Not so fast.
New research from Fidelity portfolio managers shows that simply using measures of past payouts—like recent dividends—may help achieve some of the historically higher income and lower volatility of dividends stocks, but it could also leave you overexposed to a specific sector, or holding stocks that are likely to cut their dividends.
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“There are many investors looking at their portfolio and finding that the level of income it has been generating is too low, so they’re thinking about moving a portion of their portfolio to income-producing stocks,” says Scott Offen, co-manager of Fidelity® Equity Dividend Income (FEQTX) and Fidelity® Strategic Dividend & Income® Fund (FSDIX).
“If investors are going to add income and incremental risk to their portfolio with dividend-paying equities, they should do so in the most thoughtful manner possible," continued Offen. "Backward-looking screens and passive strategies can help, but can also leave investors exposed to risk and potentially to underperformance. I think the best way to seek stock dividends is a forward-looking strategy focused on finding future dividend growth.”
If you simply took a combination of the top 20% of S&P 500® Index companies by dividend yield and low debt, measured by net debt to equity, and invested in each stock equally, you would have outperformed the index by an average 260 basis points (2.6 percentage points) a year from December 1990 to June 2011. But you would also have lived through considerable ups and downs, outperforming the index in only 11 of the 20 years. (See the graph to the right.)
“Certainly, most investors would be interested in that outperformance, but you would have to have a strong stomach to deal with periods of underperformance, and blindly following dividends could lead you to take on risk or sacrifice potential gains,” says Naveed Rahman, institutional portfolio manager on Fidelity’s equity income team.
The challenges of looking backward
There are two main reasons Offen says that a passive, or backward-looking, approach to dividend investing may not be the best approach.
Sector bias. Screens and passive strategies will not take into account how much of a portfolio is invested in a sector. That can be important because companies from similar sectors could encounter the same headwinds.
Look at the financial sector during the crisis of 2008. Financials have a long history of paying high dividends. During the past two decades, a backward-looking strategy focusing on the top 20% of S&P 500 stocks ranked by dividend yield would have had an average exposure of 22% to the sector. But as financial companies performed well and paid increasingly large dividends in the run-up to the financial crisis, that exposure climbed to 37%. Among dividend-oriented ETFs, exposure was as high as 65%. Unfortunately for many investors, overexposure to financials hurt returns—in 2008, financials were the worst performing sector in the S&P 500, losing 56% versus the broad market’s 38% decline.
“When I manage a fund, I don’t allow more than 25% of the fund to be in any one sector, and I always have some exposure to every sector to get the benefits of diversification,” says Offen.
Dividend cuts. On average during the past two decades, 10% of stocks with the highest yields cut or suspended dividends within one year—in 2009, that number reached 40%. And dividend cuts matter to investors: Historically, by the time a company cuts its dividend, it has already underperformed the market by an average of 23 percentage points in the 12 months preceding the announcement (see the graph on the right).
For dividend investors, this can be especially important. Growth investors may have big winners that can overshadow losers, but income stocks tend to produce steadier returns and have fewer high flyers—magnifying the impact of a big loss, according to Offen.
“When it comes to equity-income investing, you win by not losing,” agrees Rahman. “Not losing means you have to avoid mistakes and anticipate which companies are going to be strongest moving forward—rather than rely on backward-looking measures like historical dividend yield.”
A strategy for looking forward
What if you could predict which S&P 500 stocks would grow their dividends over the next 12 months? If you could, this hypothetical portfolio would outpace the S&P 500 in 18 of the 22 years analyzed by an average of 5.5 percentage points per year. (See chart below and to the right.)
Unfortunately, no one is able to predict the future. Still, Offen says he uses two main techniques in an attempt to judge dividend growth prospects. The first is a deep analysis of cash flow, including revenue and earnings growth, but also debt maturities, pensions, tax obligations, capital expenditures, and any other obligation with the potential to impact cash flow.
Second is an evaluation of management—specifically, the individuals’ willingness and credibility in returning capital in a disciplined way. Offen does this by examining corporate decisions, and in face-to-face meetings with management.
“With the threat of inflation and the possibility of losses, dividend growth is incredibly important,” says Offen. “I don’t think most investors are going to get the returns they want without dividend growth, and to get it you have to understand where your risks, and your opportunities, are.”
So, beware of chasing yield. When looking for dividend-paying stocks, look forward, not back. Focus on finding companies that are well positioned to grow their dividends in the future. That requires research. So if you aren’t able to do it yourself, consider the services of a seasoned manager to help.
The tax outlook
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