There has been no question that low interest rates have spurred investor demand for dividend-paying stocks in recent years. But with interest rates ticking up recently, and the potential for additional rate changes down the road, could reduced demand for dividend stocks spell trouble for this investment class?
The answer depends on the individual stock, according to Fidelity® Growth & Income Portfolio (FGRIX) Manager Matt Fruhan and Institutional Portfolio Manager Naveed Rahman. For companies that cannot increase dividends or deliver earnings growth to investors, there may be significant valuation risks. But companies that can deliver growth may deliver much stronger performance.
“In recent years, companies that offered high payouts but constrained growth have acted a lot like fixed income investments, benefitting from low or falling interest rates,” says Fruhan. “In the last quarter, we have entered a more volatile rate environment, and the market has been shifting its focus from high current income to dividend growth potential.”
Why dividend growers may be more interesting
When rates do rise, a company with limited ability to raise dividends will suffer more. Why? These companies essentially offer a fixed income stream with a very modest dividend growth component—meaning their value to investors will be determined by some of the same factors that cause a bond’s price to fall when rates rise. Think about it. If a company offered a 2.5% dividend yield and the 10-year Treasury rose from 1.6% to 2.5%, all things being equal, the dividend-yielding stock would look less attractive than it did when the bond offered less income, unless you believed the dividend or price of the stock could increase. (It is important to note that there are significant differences in risk, taxes, and potential returns between stocks and bonds.)
One sector typifies this dynamic: utilities. Utility companies generally offer relatively high payout rates, and their revenues are less economically sensitive than the average company. That means while there is less earnings risk from the ups and downs of business cycles, there is also little potential for dividend growth. As a result, when rates began to rise this year, these stocks began to struggle (see chart below).
For dividend investors, rising rates may mean that chasing high current yields or relying on a passive index or screen that looks for high payouts could potentially spell trouble. While bond proxies like utilities may see rising rates as a potential headwind, other dividend stocks may perform better, or even benefit from rising rates.
Here are four ideas of where to look for dividend stocks now.
1. Look for potential to increase dividends.
Companies that have increased dividends have historically performed better than companies without dividends in the wake of rising rates (see graph below). “The good news for dividend investors on that front is that dividend payout ratios are still near all-time lows—meaning there is significant potential for payouts to increase going forward,” according to Rahman.
Fruhan suggests looking for companies with payout ratios in the 40%–70% range and with high free-cash-flow levels and management appetite to move up into that range.
One sector with many companies that Fruhan says have the potential to increase payouts is technology. Legacy technology companies typically have stable revenue, lots of cash, and have shown increasing interest in raising payouts. For example, Apple introduced a dividend last year, and Cisco has been increasing its payout in recent years.
2. Find companies that may benefit from rising rates.
Rates often rise when the Fed is attempting to cool down an overheating economy, but this cycle may be different. The early rounds of tightening may be attempts to gradually reduce the dependence of the economy and stock market on monetary stimulus. That suggests the economy could continue to expand, which may benefit stocks that are more economically sensitive. And there are some companies in particular that have business models that can benefit directly from rising rates. The improvement to earnings, and eventually payouts to shareholders, has the potential to support these stocks while rates rise.
For example, banks may be able to earn more profits if interest rates on loans go up. Financial companies, such as J.P. Morgan Chase, may be interesting for dividend investors for another reason as well: In the wake of the financial crisis, many of these firms were required by the Federal Reserve to raise their capital ratios, meaning they had to hang on to more cash. Once financial companies reach the required capital levels, it stands to reason that they may be able to boost their payout ratios and return higher levels of cash to investors.
Other beneficiaries of rising rates are companies that benefit by earning interest on money they are holding on behalf of clients—i.e., a float. For instance, payroll companies such as Paychex, Inc., earn interest on cash they hold before employees cash their paycheck. Higher interest rates mean they will be able to earn more income off the money they hold before paychecks are cashed.
3. Consider companies with large pension obligations.
An underfunded pension is a serious liability for a company, and one that may require it to divert cash flows to close a pension funding gap. Such cash infusions can suppress earnings and stock prices. But interest rates are one of the key factors that companies use to calculate their pension liability—and when rates rise, pension liabilities tend to shrink.
“As we see the equity market kick off and interest rates go up, a lot of companies will actually move from a severely underfunded pension environment to one that is much healthier,” says Fruhan. “That could result in lower future cash infusions and less of an earnings drag, which means that valuations will start to look more attractive than they appear today.”
Fruhan says beneficiaries may include many industrials companies, among others.
4. Look for companies that inflation helps.
One more dividend idea for a rising interest rate environment has to do with inflation. Inflation has been in check for years, but rising rates tend to come on the back of a strengthening economy. If that were to happen, we may be looking at the return of inflationary pressures, and that would argue for a subset of dividend-paying stocks that can profit from rising prices and grow dividends in line with or better than inflation.
Distribution companies, for instance UPS, are one example of a business model that may benefit from inflation. These companies often have expenses that are largely fixed, but revenues that vary based on the unit costs of the products they deliver. Thus, they may benefit from rising prices.
Fruhan and Rahman argue that the rate changes seen this summer were a warning signal.
“The cat is out of the bag,” says Fruhan. “I think what you’re seeing now is that the market realizes that rates can go up, and when they do, fixed income may deliver a loss. So investments that were viewed as ‘safe’ are now being viewed in a different light. At the same time, people are also realizing that rising rates don’t necessarily mean that the equity markets have to go down. I think the market expects rates to rise again. So we have positioned our portfolios to get ready.”