2022: Year of the Dividend
In the context of a modestly higher equilibrium level of inflation going forward, dividend income is going to the superhero saviour of long-term, income-seeking portfolios.
Most investors and market pundits fail to fully recognise the importance of dividends to total returns over time. Even during the past three decades – when markets have been led higher by growth-orientated equities – 52% of the total return in the S&P 500 Index has come from receiving and reinvesting dividends.
With global dividend yields batting a better average than bond yields, it’s our expert opinion that equities can generate a greater share of portfolio income.
We’re backing equities in companies that have a consistent record of dividend growth over time, and are finding these in the healthcare, consumer staples and semi-conductor sectors. Not only do these investments offer yield – they’ve frequently outperformed the broader equity market.
Equities for the win
Many investors rely on bonds for stability and yield during times of market volatility. However, with interest rates hovering close to historical lows, everyone’s favourite defensive asset class just isn’t cutting it when it comes to generating returns after inflation.
Negative real interest rates, which occur when the inflation rate is greater than the nominal interest rate, have taken a bite out of even the most well-balanced portfolios. It’s time to look for more creative solutions.
While more volatile than bonds, equities are a strong Plan B. Steady income is distributed in the form of dividends, and they’re also known for delivering capital appreciation.
For decades, equity dividend yields were much lower than investment grade fixed income yields. That all changed, however, after the Global Financial Crisis of 2007-08 as central banks persistently drove bond yields lower. Today, equities are serving up higher dividend yields relative to investment-grade bonds.
Get your portfolio "dripping"
Urban dictionary and Investopedia have different definitions of DRIP (one means you’ve got swag, the other stands for Dividend Reinvestment Plan), but we think both apply to a portfolio that’s being fattened up by smart moves.
There’s no doubt the power of reinvesting dividends is underappreciated, and a little planning can go a long way. The way to increased returns is by investing in a select group of companies that have a solid track record of growing their dividends.
By consistently increasing payouts to shareholders over time – through recessions and expansions – these companies demonstrate their commitment to growing profits over time. Evidence suggests these dividend growers can produce higher total returns. In fact, over the last 30 years, a strategy of investing in dividend growers has outperformed the S&P 500 Index, as well as both its value and growth indices. While there is less historical data for dividend growers outside the US, we believe the same strategy can outperform globally. This is because the fundamental drivers underpinning perennial dividend growers transcend any single geography or place of business.
Focus on dividend growth, not high dividend yield
When it comes to dividends, size doesn’t always matter. The quality of the dividends, however, does. Companies that can consistently grow dividends tend to outperform those with unsustainably high payouts that they ultimately have to suspend or reduce.
Over the last 47 years, dividend growers’ outperformance of dividend cutters is more than 3% a year, and with 30% lower volatility. The same companies that have a record of dividend growth often exhibit moderate levels of dividend yield, payout ratios and leverage. In turn, they have tended to deliver stronger long term performance than both higher and lower yielding alternatives.
By contrast, high dividend yield strategies often come with indicative yields more than double that of the broader market, which may seem alluring to investors. Those higher yields could hint to additional risks though.
We find that the companies with the highest nominal yields of all actually have lower cash flow generation, lower return on equity and higher leverage. In these cases, the very high yield is a warning sign that the firms are paying out an unsustainably high proportion of profits as dividends and that investors may expect a cut.
Earning income in portfolios has seldom been more challenging, and there doesn’t seem to be much relief on the horizon for investors. While interest rates may rise from current levels, we don’t expect them to do so by much. Yields on cash and many bonds are likely to remain meager. If that’s the case, dividends from equities will replace some of the income no longer available from cash and bonds.