Balancing Income and Uncertainty
“If earnings not paid out in dividends are all successfully reinvested…then these earnings should produce dividends later; if not, then they are money lost.”
John Burr Williams
Bulls, bears, banks, and the Federal Reserve. The first quarter of 2023 proved to be a wake-up call for investors as the effects of persistently higher interest rates spilled over into the economy in unexpected ways.1 Nevertheless, the broader equity indices held up fairly well in Q1 (S&P 500 +7.0%; DJIA +0.4%; NASDAQ +16.8%), supported mainly by the growthy, “risk-on” sectors of the market.
The recent volatility has given many investors the impression that the Fed’s moves toward more restrictive monetary policy may be coming to an end, a perceived tailwind to growth-oriented businesses. As we wrote in our Fall 2022 Insights newsletter, a “stabilization of interest rates [was likely to] presage the next equity market recovery.” 2 Recent banking disruptions aside, could a sustainable bull market be on the horizon? Either way, it is income-oriented investors that may likely stand to benefit most.
The most obvious impact of “normalized” monetary policy is on the price of credit. A pause or end to the Fed’s cycle of raising short-term policy rates would remove much of the upward pressure on bond yields and, in turn, downward pressure on bond prices. But stabilized—or potentially even declining—interest rates would be good for dividend-paying stocks as well. While stocks of course do not offer the same security and principal protection as high-quality bonds (like U.S. Treasuries), those that pay dividends on a consistent basis typically help defend from moderate volatility while retaining strong upside potential. If bond yields fall, steady dividend-paying stocks could look comparably attractive. And if markets remain volatile, dividends can go a long way in absorbing some of the impact.
Consider the small sample of 30 stocks that comprise the Dow Jones Industrial Average (DJIA). Applying a ranking model to this group that rewards the most consistent dividend payers who have meaningfully grown their payouts over time produces a subset of 15 high quality companies, which can be evaluated each year and rebalanced as necessary. These companies have, on average, paid and increased their dividends through all economic regimes while maintaining the underlying financial strength characteristic of a “blue chip” Dow stock. They also have, historically, outperformed the broader DJIA index itself (Figure 2).
These stocks do not just outperform on upswings either; cumulative losses for the top 15 dividend payers came in slightly lower than those of the entire Dow 30 during downturns as well. In fact, during some years where the DJIA ended “in the red,” the high-quality dividend-paying group delivered positive total returns due to the consistency of their generous payouts. And when compared to the other 15 stocks in the index, the difference in performance was substantially more pronounced (Figure 3).
Bear in mind, however, that one should not pick stocks based solely on their dividend record. After all, there are plenty of non-dividend paying companies (such as Alphabet, Amazon, and Berkshire Hathaway) that have generated impressive returns on price appreciation alone. And while valuation methodologies anchored in dividend payouts are straightforward, they are in turn often too dependent on a single variable. A dividend cut is not outside the realm of possibility for even the strongest of companies. That said, there are simple ways to incorporate a company’s dividend merits into a more comprehensive analytical framework. When our analysts at Boston Research & Management evaluate new equity ideas, factors such as valuation multiples and growth estimates for sales and earnings are run through a sensitivity analysis with the goal of producing an expected “internal rate of return,” or IRR. The company’s dividend yield—if any—is then added to this figure, netting the stock’s annualized total return potential. Though IRRs are just one tool in the toolbox, they are a helpful guidepost in determining whether a stock might be a worthy investment. Typically, we target at least a low double-digit IRR to even consider a stock for inclusion in our portfolio, as this provides a sufficient margin of safety should any one of our expectations—in terms of valuation, growth, or otherwise—not be fully realized. In some cases, it is the added benefit of a strong dividend yield that ultimately pushes an IRR above our minimum threshold. If a company were to not grow as much or as fast as projected, its dividend payments could make up for the shortfall.
Moreover, data shows that dividends have accounted for roughly 40% of the S&P 500’s total return since the Great Depression, a clear indication that, even with price volatility, dividend income can be a substantial driver of wealth generation. In short, during times of momentum-driven prosperity where growth stocks may appear most attractive, do not overlook the compounding benefits and value proposition of steady dividends. On the other hand, when uncertainty and volatility reign, remember that the strongest dividend-paying companies can provide some shelter from the storm, throwing off consistent and often generous cash returns while investors await calmer seas.
1 Hindsight is always 20/20, but the sudden turmoil within the Financial sector, particularly among regional banks, resulted in some of the largest bank failures since 2008. It is hard to imagine many had that on their 2023 economic “bingo card.”