Recent markets have driven some investors to take a new look at dividend-paying stocks. Some may be looking for alternative income as yields on traditional bonds remain stubbornly low. Others may be concerned about volatility or future prospects for stocks, and perceive dividend-paying stocks as an attractive part of the market. 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 boom, you’re done. Right? Not so fast.
Chasing yield, by looking back at recent dividends, can come with some risks. Research from two Fidelity fund managers shows that a better strategy may be to look for stocks that may be able to grow their dividends.
“If investors are thinking about adding dividend-paying equities to their portfolios, they should do so in the most thoughtful manner possible," says Scott Offen, co-manager of Fidelity® Equity Dividend Income (FEQTX) and Fidelity® Strategic Dividend & Income® Fund (FSDIX). "Backward-looking screens and passive strategies can help," adds Offen, "but they can also leave investors exposed to sector concentration or the risk of dividend cuts hurting price returns. I think the best way to seek stock dividends is a forward-looking strategy focused on finding future dividend growth.”
What if you simply invested an equal amount in the 20% of S&P 500® Index companies with a combination of the highest dividend yield and lowest net debt to equity, and then rebalanced quarterly? From December 31, 1990 to December 31, 2015, you would have outperformed the index by an average 2.04 percentage points a year. But you would also have lived through considerable ups and downs, beating the index in only a little more than half (51%) of the 12-month periods within that time frame. (See the chart.)
“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 financials 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 21% 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 was the worst performing sector in the S&P 500, losing 56% versus the broad market’s 38% decline.
“When I manage a fund, I generally 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, 9% of S&P 500 stocks with the highest yields cut or suspended dividends within one year—in 2009, that number reached 40%. And the financial conditions that cause companies to cut dividends have big implications for investors: Historically, the average security that cut or suspended its dividend underperformed the market by more than 25% in the 12 months preceding the announcement. (See the graph.)
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.”
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 21 of the 25 years analyzed by an average of 4.18 percentage points per year. (See the chart.)
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 management’s willingness to returning capital in a disciplined way. Offen does this by examining corporate decisions, and in face-to-face meetings with management.
For example, the global medical diagnostic company Medtronic (MDT) was trading at a little over 17 times estimated earnings early in 2015, which represented a discount relative to the overall health care sector. Offen and Rahman thought this represented a good value for a stable earnings grower they felt was poised to continue to benefit from the acquisition of rival Covidien, global expansion opportunities, and growth from new products. With a payout ratio below 40% and solid earnings growth, the company was able to deliver dividend growth north of 20% in 2015, enabling the company to return almost 9% in the year, far outpacing the S&P 500 return of just over 1%.
Offen and Rahman cited other companies that have met their criteria, including Chubb (CB)—a leading property and casualty insurance company that recently formed from the acquisition of Chubb by ACE. The newly formed company spans commercial, personal, and life insurance as well as re-insurance across many geographies; it had traded at less than 12 times estimated 2016 earnings with a 2.3% dividend yield.
Rahman also pointed to Cisco (CSCO) a technology hardware company focused on network switches and routers. The company has traded at less than 12 times its 2016 earnings estimates, which Rahman believes has made Cisco one of the better valued companies in the technology sector, while the company has adopted a more dividend friendly approach to capital allocation over the last several years. It has grown its dividend by more than 50% over the past three years, and currently yields 3.8%.
“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. If you aren’t able to do it yourself, consider the services of a seasoned manager to help.