The creators of the iconic board game Monopoly were onto something when they made receipt of a bank dividend a sought-after reward for a propitious roll of the dice.
But though the benefits of income to a stock's total return are well known — since 1926, about 45% of the total return of the S&P 500 has come from dividends — investors' increasingly aggressive hunt for yield in recent years argues for a more refined, nuanced and calibrated approach. In short, it is important that financial advisers understand that not all dividends are created equal.
In our view, the long stretch of exceptionally low real and nominal yields available from the capital markets since 2008 has led to a state in which many investors have become willing to overreach for dividend income. Indeed, what appears to be severe overvaluation of some income-producing equities — most notably in the utility, consumer staples and telecommunications sectors, where relative valuations are near 50-year highs — is further evidence that yield-starved and, ironically, risk-averse investors are aggressively chasing yield, the higher the better, with few other questions asked.
MISLEADING NUMBERS
It is illusory to view a stock yielding 6% as necessarily a better investment than one yielding 4%.
The historical record reveals that while dividend-paying companies overall have bested those that don't pay dividends or those that cut their dividends, total returns have been highest on companies that actively increase their dividends, as distinct from those that simply pay dividends. (Of course, there is no guarantee that dividend-paying stocks will continue to pay dividends.)
Over the 16-year period ended Dec. 31, dividend growers returned, on average, 6.9% per year on a market-weighted total return basis, compared with 6.8% for all dividend payers, 6.1% for non-dividend payers and -1.1% for companies that cut their dividend distributions.
Equally important, the outperformance of dividend growers was accomplished with reduced volatility. Over that same span, market-weighted annualized volatility among dividend growers was 14.3%, versus 15.4% for all dividend payers, 16.3% for the S&P 500, and a whopping 23.3% for non-dividend payers and 29.7% for dividend cutters.
These figures clearly demonstrate that there is more to investing for equity income than simply choosing the highest-yielding stocks, especially since determining a company's ability to grow its dividend requires specialized research capability. Equity-income managers are expected to identify companies whose dividend growth could stagnate, increase or reverse before that information becomes embedded in a stock's price.
The most astute corporate boards and management teams also recognize that dividends are an important signaling mechanism to investors. Accordingly, significant time and energy is (or should be) expended in crafting a prudent and sustainable dividend policy.
Regularly increasing, rather than simply maintaining or, worse, cutting a dividend, typically functions as a clarion call to the market about the health of an underlying business both now and in the future.
It also is important to note that, from our perspective, even a growing and well-covered dividend isn't a sufficient reason to own a stock. It is vital that the company's longer-term outlook appear favorable, as well.
A diversified income-producing fund should have the flexibility to exploit attractive income opportunities outside the equity asset class, such as in high-yield bonds, real estate or the mostly inefficient convertible bond space, for example.
LIKE MOTHS TO A FLAME
Of course, we recognize that individual and institutional investors alike often are drawn toward whatever product is considered hot, and in this unnaturally low-rate environment, chasing dividend yield has generally been a profitable enterprise. Then again, so was buying dot-com stocks in the late 1990s, or Miami condos in the mid-2000s.
This isn't to suggest that an equal comeuppance awaits the most egregious forms of equity yield-chasing. We are mindful, however, that even sound strategies can be taken to unreasonable extremes and the indiscriminate accumulation of the highest-yielding stocks on that basis alone is misguided in our view.
The global dash for yield is in its later innings. The time has arrived to be more discriminating in choosing dividend-paying stocks. Credit quality, not the size of the dividend, should be of paramount importance.
Bob Zenouzi is chief investment officer for real estate securities and income solutions at Delaware Investments.
