Boston - When building an equity portfolio, investors tend to choose between yield and growth. But as a storm of new market forces injects uncertainty and volatility into the investment process, we believe a comprehensive dividend strategy — one that selectively combines "sustainers" and "growers" through an active management approach — may offer a better solution to today's market dynamics.
What are sustainers?
Companies that have demonstrated the ability to maintain their dividend payouts — what we call sustainers — have historically provided some protection against the downside along with above-average, sustainable income.
Let's consider the 10 most severe drawdowns in the S&P 500 Index since 1973 and how different quartiles of dividend-paying stocks in the index, sorted by their dividend policies, performed over these periods, as calculated by Ned Davis Research. Over these down market periods, sustainers have, on average, outperformed the S&P 500:
Source: Ned Davis Research (data provided by Refinitiv, S&P Dow Jones Indices) data from 1973 to June 30, 2022. Top 10 worst monthly drawdowns of the S&P 500 since 1973. Dividend Sustainers = stocks with positive trailing 12 month year/year dividend growth, including dividend growth stocks, that haven't cut their dividend. 2nd Highest Quartile Dividend Yielder = second highest yield bucket if all dividend paying stocks are sorted into quartiles, typically found to be more reliable higher-yielding dividend stocks since the highest yielding quartile tends to include deep value stocks or businesses with poor fundamentals. High Yielding Sustainers = subset of dividend sustainers including only those stocks whose yield at the date listed was greater than the S&P 500 yield. All Dividend Paying S&P 500 Stocks = every stock in the S&P 500 that pays a dividend. Dividend Cutters or Eliminators = stocks within the S&P 500 that have cut or eliminated their dividend; these companies structurally underperform, and typically don't hold up in down markets. Batting Average = percent of months when each category outperformed the S&P 500 during the worst drawdowns. Past performance is no guarantee of future results.
In actively selecting sustainers, we believe durable balance sheets, low debt ratios and high free cash flow are all important. With a dividend investing approach that focuses on what we would consider to be high-quality sustainers with these characteristics, an investor may be able to achieve a dividend yield that exceeds the average yield of the S&P 500.
What are growers?
Dividend growers are securities that we believe have demonstrated better growth prospects than their value-focused counterparts in the Russell 1000 Value Index. As investors, we believe it is essential to focus on quality companies that may have the capability to compound dividend growth, along with low payout ratios and attractive free cash yield.
Having the opportunity to periodically invest in "initiators," or companies that may be poised to initiate a dividend growth strategy, can also be a differentiator for a dividend strategy. Historically, companies that have initiated and/or increased their dividends have tended to outperform non-dividend payers or stable dividend payers. Our research suggests that they also have the potential to outperform the S&P 500, as dividend growth can be reflective of earnings growth.
Dividend growth may help neutralize inflationary pressures, since it has historically outpaced the rate of inflation over time. This exhibit from Ned Davis Research depicts how dividend growers and initiators have served as a strong inflation hedge. For context, these stacked graphs indicate that during periods of "elevated inflation" above 6% (bottom panel), holding dividend growers and initiators may help to generate alpha, shown as a ratio of return relative to the S&P 500 (top panel). The converse may also be true, however: Holding non-dividend paying stocks in those periods may generate negative alpha.
Past performance is no guarantee of future results.
Avoiding dividend traps
A dividend trap refers to a stock that may offer a high dividend yield, but that yield is not supported by the issuing company's strategic, operational and financial attributes. Perhaps the management team lacks the skill to reinvest cash to build the business and simply gives it away to shareholders. Or maybe they are slow to adjust to competition or market conditions.
The net effect is that dividend traps can lead to dividend cuts, and dividend cutters have generally exhibited the greatest underperformance relative to the S&P 500 during the 10 worst monthly drawdowns, as shown in the table above.
We believe that selectivity — supported by rigorous fundamental research — can be key to avoiding dividend traps. In our investment process, we use sophisticated balance sheet and cash flow analysis to evaluate and avoid potential cutters.
We also examine our investment holdings using a combination of fundamental and environmental, social and governance (ESG) factors, with Calvert investment criteria applied to every holding. This helps identify and mitigate risk factors that others may miss.
Bottom line: Rising interest rates and slowing economic growth — along with the fastest pace of Consumer Price Inflation (CPI) since 1981 — have combined with war and energy shocks to roil the markets. During these turbulent times, we think it may be time to reconsider dividend stocks. We believe a comprehensive dividend strategy that selectively combines a mix of high-yielding sustainers and growers can offer three key attributes:
- Higher probability of downside capture during periods of volatility
- Historically attractive hedge against inflation
- Generally stable and growing income
As we see it, this approach could be particularly powerful in today's market environment.
S&P 500® Index is an unmanaged index of large cap stocks commonly used as a measure of U.S. stock market performance.
Russell 1000® Value Index is an unmanaged index of U.S. large cap value stocks.
It is not possible to invest directly in an index. Past performance is no guarantee of future results.
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