By Marcus Weyerer, Senior ETF Investment Strategist at Franklin Templeton
After all, it’s pretty straightforward, right? You select a bunch of high-yielding stocks, put them together into a portfolio and, there you go. But, how does one select the stocks? By yield only, or should other criteria matter, too? How should the allocation weights be determined? By market cap, by yield, or by something else entirely? To an extent, as is so often the case, the “correct” answers depend on the specific needs of the investor. But the idea that all dividend strategies are created equal is demonstrably an oversimplification.
Dividend investing is only a matter for the expertise of active managers, not for ETFs
This is an impression in stark contrast to myth number one, but just as misguided. While active management can add value in dividend strategies and may be right for some investors, this usually comes at a cost – both financial and otherwise. The effort required for the due diligence of a bottom-up manager (focusing on company specifics ahead of wider macroeconomic factors) and the risk of a style-drift are just two examples.
Active fundamental managers often base their analysis on a company’s three financial statements: the income statement (IS), the balance sheet (BS) and the cash flow statement (CF). Each contains important numerical information that can be standardized and used within a purely quantitative, rules-based investment strategy. At Franklin Templeton, we focus on the following criteria:
• Return on Equity (from the income statement and balance sheet),
• Earnings Variability (IS),
• Cash Return on Assets (CF, BS)
• Debt-to-Assets (BS)
This methodology mimics an active manager’s approach without making discretionary decisions on when, for example, to buy or sell.
The higher the dividend yield, the better; after all, that’s the point of dividend investing!
The point of dividend investing, is, well, to receive attractive dividends – that much is true. But we think that this is only part of the story. Focusing solely on high dividend yields comes with at least two risks: first, that one ends up with a very concentrated portfolio of only a handful of sectors or stocks; second, that the high yield may never be realised because the company runs into trouble, has to cut or stop its pay-outs, or worse, goes into default. There is no guarantee that this won’t happen to higher quality companies, but fundamentals, especially profitability, matter. A low-profitability company will either have to pay out large portions of its (low) earnings, foregoing investments into future growth opportunities, or dip into its reserves. Neither can be sustained over the long run, and the stock might turn out to be a “dividend yield trap”. There are no hard and fast rules as to what constitutes too high a yield. Our approach is therefore to balance attractive yields against a track record of stable or rising dividends and a quality assessment of the firm in question.
Rising interest rates are bad news for dividend stocks
In fact, the opposite may be true. In the two prior Fed rate hike cycles from 2004 to 2006 and from 2016 to 2018, equities in general performed well, and dividend payers significantly outperformed the broad market during the first cycle and slightly underperformed during the second. The difference between high quality dividend stocks and high dividend yielders was small in both instances. The intuitive economic rationale is that, while mathematically detrimental to asset values, rising rates can signal a robust economy with central banks stepping in to prevent overheating and a subsequent recession.
Now, the current situation is likely somewhat different this time around. First, recession talk is rampant as the global economy is dealing with an unprecedented fallout from two events not seen in decades; the Covid-19 pandemic and a war in the heart of Europe. Second—and partly as a consequence of the first point—inflation rates have hit multi-decade highs and monetary policy has to play catch-up with relatively less regard to the shape of the economy. As a matter of fact, a recession might become necessary to bludgeon inflation.
In short, hard data does not support the hypothesis that dividend stocks have to underperform during rising rates. So far in 2022, dividend strategies have indeed been a relative haven compared to broad equity markets. We believe that going forward – without the lavish central bank support markets have grown accustomed to – companies with strong fundamentals and attractive yields could do well in a scenario of moderating inflation and interest rates that still remain higher than in the past two decades.
Dividend stocks are always the safer, more defensive choice compared to the broad market
During the March 2020 selloff, for example, the difference between most dividend strategies, including quality dividends, and the broad market was relatively small. There was a sense of panic, and fundamentals, in the heat of the moment, no longer appeared relevant to many. It’s difficult to determine the fair value of a company even during the best of times, but steady dividends to investors may provide a more objective valuation floor through approaches like the dividend discount or other discounted cash-flow models that are harder to use for growth companies or the broad market.
Nonetheless, dividend investors should beware of a false sense of safety. Over the medium and long term, however, investors combining yield and quality can at least have a high confidence that their holdings will make it through the drawdowns eventually – while continuing to pocket steady pay-outs.