The Tip of the Iceberg For Dividend Stocks
June 13, 2012
More companies are able to initiate and raise dividends just when investors want them most
- Post-crisis equity investors seek to lower portfolio volatility. Dividend stocks have provided higher returns with less risk compared with non-dividend payers.
- Baby boomers are retiring now with much smaller nest eggs than they had anticipated. They need reliable sources of income and growth.
- Cash-rich companies are
in a position to pay and potentially grow dividends, while dividend payout ratios are historically low.
- Active managers leverage in-depth research to uncover promising opportunities among companies likely to initiate or raise dividends.
After a strong performance from dividend stocks in 2011, many investors are wondering what lies ahead for the group. In our view, a combination of forces has created a compelling opportunity in dividend stocks today and for the long term.
On the one hand, investor demand for dividends is strong, driven by a post-crisis desire to reduce portfolio volatility, a need for income among baby boomers entering retirement and the appeal of potential income growth inherent in the stocks. At the same time, cash-rich corporations are now in a strong position to pay dividends and possibly increase them from today’s historically low levels. The key for investors will be identifying companies likely to initiate or raise dividends — two actions historically seen in dividend stocks that outperform.
Post-crisis equity investors seek to lower portfolio volatility
In the wake of the economic downturn, many investors are seeking to reduce portfolio volatility and preserve wealth. Behavioral finance studies show that people give greater weight to their most recent experiences. We not only
focus on what has happened recently but also tend to over-generalize to the future.1 Thus, we often believe recent bad news means the future will unravel — perhaps very quickly. In addition, the theory of loss aversion suggests that we experience deeper emotion from a loss than we would from an equally sized gain. It’s no wonder then that many investors remain focused on reducing portfolio risk, even amid signs of an improving economy.
Historically, dividend-paying stocks have been among the more conservative areas of the equity market, offering investors a lower volatility, higher quality option. Dividend-paying companies tend to be established, well-managed enterprises with recognized brands. As a result, in down markets they often retain value better than non-dividend payers do.
In fact, companies that raise or initiate a dividend have historically generated strong returns with less risk than companies that do not pay a dividend (Exhibit 1). Even companies that pay dividends but do not increase them have outperformed non-payers by a wide margin.
Baby boomers are retiring now, and need sources of income and growth
Retirees are more reliant than ever on investment income. Next to Social Security, investment income is the largest source of income for retirees.2 It’s also under the most pressure given today’s historically low interest rates. In fact, since 1984, Treasury yields have been trending downward, with the safest, shortest-term rates now near zero.
The latest direction from the Federal Reserve indicates short-term rates are likely to stay close to zero until at least mid-2013. Some investors don’t expect a turn in rates until 2014. Even when rates do rebound, there is little likelihood the increases will be sharp given the Federal Reserve’s vigilance in controlling inflation.
Meanwhile, the financial crisis has ravaged the portfolios of many baby boomers, leaving them with little to no time to make up those losses before they start drawing down their savings. Instead, they face entering retirement with
a much smaller nest egg than they had counted on.
Although they’re not the only source of investment income for retirees, dividend-paying stocks can offer two important advantages:
- Capital appreciation potential. Carefully selected dividend companies could provide reliable income as
well as share price appreciation potential without adding significantly more risk to a retiree’s overall portfolio.
- Income growth potential. Unlike fixed-income instruments, corporations have the flexibility to increase dividend payments on stocks. This can boost the total return for investors who reinvest the dividend and result in higher payments to investors who rely on the income from dividend distributions.
Conservative retirees may also find dividend stocks preferable to more speculative equity categories.
Cash-rich companies are in a position to pay and potentially grow dividends
Throughout the financial crisis, company managements focused on cost cutting and strengthening balance sheets in order to remain competitive. As a result, many are now operating from lean, highly efficient positions. They’re also rich with cash.
Non-financial U.S. companies rated by Moody’s Investors Service held $1.24 trillion in cash as of December 2011, up 3% from 2010’s record of $1.2 trillion.3 The Federal Reserve reports that cash levels among non-financial companies are the highest they’ve been since the central bank began tracking the figures in 1952.
With interest rates historically low, high cash levels are dilutive to the corporate balance sheet. In order to demonstrate their wise stewardship of capital, managements must put that cash to work. They have
a few options:
Reinvest capital back into the company through research and development (R&D)
- Pursue mergers and acquisitions (M&A)
- Initiate share buybacks
- Initiate or raise dividend payments to shareholders
Arguably, many companies have ample cash to enact more than one of these options.
We believe dividend actions will be a preferred choice among boardrooms. The lessons learned from the financial crisis suggest that managements are likely to remain focused for some time on maintaining ample cash levels, continuing to run lean and using cash in shareholder-friendly ways.
In addition, favorable dividend actions tell investors a company is strong, its debts and other liabilities are covered, and it is operating efficiently. Thus, initiating or increasing dividends is one way managements can help build and/or restore investor confidence in their stock.
In our view, the stage is set for a long-term uptrend in dividends. The S&P 500 Index dividend payout ratio is currently near 30% compared with a historical average of closer to 55% (Exhibit 3). Given today’s high corporate cash positions, we expect a steady increase over the next several years.
Potential dividend tax increase — will it matter?
With the so-called Bush tax cuts due to expire on December 31, tax rates on dividends for wealthier investors have a real chance of rising from the current 15% rate to a high of 39.6%. Does this undermine the attractiveness of dividend-paying stocks? In our view, a tax increase would not substantively affect the valuation of dividend-paying equities for a few reasons:
- The increase is not a given. Older, income-focused voters have significant political might.
- The tax would only affect individuals with incomes greater than $200,000 or joint returns of more than $250,000. Based on IRS data, 35% of dividends paid to individuals went to taxpayers making less than $200,000. Total dividends received by individuals making more than $200,000 (only 3.2% of tax returns) was about $244 billion (2007 data), but only $101 billion of that was in the form of qualified dividends, the area affected by this potential change. Therefore, only 40% of the dividends received by those 60% of the people affected, or a total of around 24%, would be at risk.
- In our opinion, wealthier investors are likely to react by rechecking how they hold dividend-paying accounts and, in all likelihood, would allocate income more aggressively into non-taxable savings vehicles.
After assessing all the puts and takes, we conclude that the effects of this potential tax action are unlikely to have a significant impact on how the market values dividend-paying equities. In fact, the more we dig into this issue, the more it strikes us as a very ineffective way to increase government tax yields.
Yield in (once) unexpected places — non-traditional dividend-paying sectors
From Columbia Management 2012 Perspectives “The Evolution of Dividend Investing and the Rise of Non-Traditional Dividend Sectors” by Paul Stocking and Laton Spahr.
We believe that the recent behavior and outperformance of the highest dividend stocks has laid the groundwork for a shift toward new dividend themes moving forward.
The high relative valuation in sectors like utilities and staples has opened up an opportunity to look at nontraditional dividend sectors like technology, basic materials and consumer discretionary to find hidden dividend gems with increasingly sought-after characteristics, such as high yield and predictable dividend growth.
As a result, we expect faster adoption of more shareholder-friendly dividend policies across the market, allowing new leadership to emerge in the sweet spot of high dividend/high growth.
Today, dividend stock portfolio managers are finding value in two places:
- The dividend aristocrats. Attractive dividend payers typically have a long-term record of returning value to shareholders through dividends, including a history of consistently paying and increasing dividends. Known as the dividend aristocrats, these companies have solid balance sheets and long-term track records of being wise stewards of cash.
- Non-traditional dividend-paying sectors. Many mature companies
that are no longer in the expansion phase have solid cash positions, making them candidates to become dividend payers. They have the ability to initiate a dividend and the long-term ability to increase dividends (see sidebar on page 4).
The stage appears set for ongoing opportunity among dividend-paying stocks. Investors are seeking the very benefits that dividend stocks provide, including low volatility and income that can potentially increase
in the future. At the same time, strong corporate cash positions and low dividend payout rates suggest there are many companies today that are capable of initiating and raising dividends. And history tells us this is more important than the yield itself in determining which stocks will outperform. We believe portfolio managers who can identify the dividend leaders will find this is only the tip of the iceberg for dividend stocks.
Active managers leverage in-depth research to uncover today’s opportunities
In our view, the greatest potential today lies not in the highest yielders, but rather beneath the surface among high-quality companies with the potential to grow or initiate a dividend. Exhibit 1 illustrated the overall risk/return tradeoff of dividend payers vs. non-payers.
Exhibit 4 broadens the analysis by 30-plus years and breaks out the returns by holding period. The results are telling:
- Companies that have raised their dividend outperform an equally weighted universe of companies by approximately two percentage points in the year following the increase.
- They continue to outperform for up to three years later.
- The market seems to discount the corporate decision to increase the dividend for a year prior to the dividend action.
These statistics tell us that successful dividend stock selection requires the ability to anticipate which companies are likely candidates to raise or initiate a dividend.
Active portfolio managers leverage intensive research to identify opportunities among dividend stocks. Professional portfolio managers and research analysts dig deep into a company’s ability to generate and sustain cash flow. When a corporation’s cash returns exceed what it needs to grow the business, it has the firepower to initiate favorable dividend actions. That said, not all dividend-paying stocks are the same. Companies can cut dividends as well as raise them, which is one reason careful analysis of each stock is important.
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The views expressed are as of April 2012, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate.
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