Dividend stocks tend to outperform when the stock market is uncertain. It’s been true historically, and it’s been the case again in 2016. There’s safety in stocks that have had strong balance sheets and reward shareholders with regular cash payments.
Case in point: The S&P 500 is down 6 percent this year, trailing by a wide margin the S&P Dividend Aristocrats Index (-1 percent) and S&P High Yield Dividend Aristocrats Index, which is flat.
“It’s a very uncertain market, and you don’t know where returns will come from, but you can expect they will be lackluster,” said Neena Mishra, director of ETF research at Zacks Investment Research. “For sure, investors will be better off to get some dividends and high-quality companies with a history of cash on the balance sheet,” she said.
The Federal Reserve may still talk about raising rates this year, but rates don’t seem likely to go up as far or as fast as the market once assumed. That means the argument that dividend-rich sectors would become less attractive relative to rates doesn’t have much weight behind it, especially since many classic dividend stock niches are also “flight to safety” sectors. Wondering why utility stocks are actually up 6 percent this year amid the stock market rout? There’s your answer.
When the markets are a mess, dividend stocks need to be on the radar of investors, experts said. And with global growth slowing, C-suites don’t have much to offer investors to get their stocks moving up beyond cash reward programs: Look at Apple’s recent bond offering, taking advantage of the low rates and ability to use bond proceeds to increase dividend payments.
“The market believes there will not be a rate hike or just one, and dividends have been outperforming based on that belief,” Mishra said.
Ben Johnson, director of global ETF research at Morningstar, said that these type of companies typically have strong, steady earnings and a clean balance sheet. “They’re profitable and healthy,” he said. “And they have a sustainable competitive advantage to keep competitors at bay.” It’s become apparent to investors that dividend investments, including ETFs, have been resilient in “what has been a brutal downdraft for equities.” He added: “This is their time to shine.”
If you’re already a dividend investor, it’s time to check that your approach is set correctly. If you’ve been neglecting dividends, it’s time to consider a plan.
Here are four questions to make sure you make the most of dividend investing.
1. Is it better to buy individual dividend-rich stocks or dividend funds and ETFs?
The best way to answer this question is by looking at the overall size of your investment portfolio, said Charles Sizemore, a financial advisor at Sizemore Capital Management in Dallas. “If your portfolio is a few tens of thousands of dollars, just buy an ETF or a few ETFs and be done,” he said. “ETFs will pay a decent yield, and the risk is so low. If you own a dividend stock or two and they blow up, it can sink your entire plan.”
Sizemore said only investors with several hundred thousands of dollars should be picking individual dividend stocks.
The ETFs are a low-cost, diversified way to own dividend-paying companies of all stripes, Morningstar’s Johnson said.
“For the vast majority of investors, one steady, high-quality, core low-cost U.S. equity income fund is more than sufficient,” he said.
Either way, it is important to remember that an ETF, even one with a high yield, is not a bond investment. “Dividend-growth ETFs can bounce around a lot,” Sizemore said. “These are stocks, not bonds.” But most of the ETFs in this category are focused on holdings that “have survived Armageddon. So they’re a valid way to play dividend growth,” he added.
2. What sets dividend stocks and funds apart is the yield, but is absolute yield the most important factor in selecting a dividend investment?
Yes, yield is what distinguishes dividend stocks, but the further an investor stretches for income through high-yield ETFs implies “a sacrifice of quality,” Johnson said.
The Morningstar ETF expert said it is important not to look at yield in isolation. “Yield is market-dependent,” he said, referring to the fact that as a stock declines in value, a yield will increase. But it’s more important to look at the stability of the cash-flow stream of a company. Consider the energy sector, where yields have been going up as stock prices go down, but cash flow is not safe, given the sector free fall amid low oil prices.
It is more important to see cash flow growing over time rather than yield in isolation, Johnson said. Investors do want to see a yield that is steadily growing at a pace that outstrips inflation.
Johnson also provides a handy study of maximum drawdown in dividend ETFs — it provides investors with a sense of what a worst-case scenario would look like for various ETFs if they had declining dividends.
“See how their dividend stocks performed in the last recession,” Sizemore said. “Yield by itself is relevant, but not the most relevant.”
The Vanguard Dividend Appreciation ETF (VIG) is a Morningstar favorite. It tracks an index composed mostly of large companies that have raised their dividends for at least 10 straight years. And most of the 179 holdings aren’t the usual dividend-heavy stocks, like REITs or utilities. Stocks include consumer goods and industrial stocks, which can plug into economic recovery. The expense ratio is only 0.10 percent.
“This Vanguard ETF has great dividend growth,” Sizemore said. “You’re buying a portfolio of bullet-proof companies that have increased dividends consistently.”
“The market believes there will not be a rate hike or just one, and dividends have been outperforming based on that belief.”
3. Does the length of years a stock has been paying dividends, and maybe increasing them, matter in selecting a dividend investment?
Reliability of cash flow and dividends over a number of years is essential, but how many years, exactly? This could be the most important question when it comes to choosing a dividend ETF, specifically.
The Schwab US Dividend Equity ETF (SCHD) is another favorite of ETF experts. It tracks companies that have raised dividends for at least a decade. It’s also a low-cost ETF, with a fee of only 0.07 percent. “The less fees you pay, the better,” said Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ.
But more important in this case may be the fact that the Schwab ETF gets 20 percent of its exposure from the tech sector, Rosenbluth said. He owns stocks like Microsoft and Intel, while also holding more traditional dividend sectors, such as industrials.
Sizemore said S&P Dividend Aristocrats Index, the basis for a ProShares ETF (NOBL), only includes stocks with a 25-year history of raising dividends. While that means the dividends are “close to bulletproof,” the downside is investors don’t get the tech-sector names like Apple or even Microsoft, which have emerged as some of the fastest-growing dividend payers.
“You’re getting a core of old consumer staples and old industrials that have been around forever,” Sizemore said. “It’s not bad, but those stocks are kind of expensive.” In his view, with the stock market in the latter stages of a bull market run, sectors like consumer staples aren’t trading at prices that Sizemore sees as being a good entry point. “I don’t want to overload on these sectors,” he added. “They won’t have to cut dividends, but the problem is, the stock prices aren’t that compelling.”
The SPDR S&P Dividend ETF (SDY), which tracks the S&P High Yield Dividend Index, tracks a benchmark that holds the highest-yielding companies that have increased their dividends for at least two decades. Nearly a quarter of the ETF’s 99 holdings are financial stocks, and it has much fewer technology stocks.
But length of years tracked can be deceiving: A shorter dividend history as a basis for an ETF doesn’t always mean more tech. The iShares Core Dividend Growth ETF (DGRO) was just launched last year. Its benchmark index shoots for stocks with at least five years of straight dividend growth and high payout ratios. Top holdings include Microsoft and GE. But Sizemore said even though it’s limiting its holdings to the past five years of dividend history, “you’re not getting the fastest-growing companies.”
Tech represents 13 percent of this ETF. “The ETF has a low expense ratio of 0.12 percent, and it’s pretty diversified,” Mishra of Zacks Investment Research said.
Vanguard’s VIG ETF also has 13 percent exposure to tech and Microsoft as its top holding, but a 10-year requirement for dividend payment history.
Overall, “10 years is a nice round number,” Sizemore said. “As an investor, you can figure that in any 10-year window, the companies have seen one recession. Clearly, it takes a high-quality company with substantial staying power and cash flow to generate and grow a dividend over 25 years, but what an investor also might miss out on is emerging dividend players.”
Sizemore said for “gobs and gobs of cash flow being returned to shareholders, it’s been tech in the past five or so years.”
4. The energy sector has been great for dividends, yet more dividend cuts from energy companies are coming. Will it be a huge drag on dividend income indexes and funds that are benchmarked to them?
Energy is the most vulnerable sector to big dividend cuts. In the past week alone, two big U.S. oil and gas companies, ConocoPhillips andAnadarko Petroleum, slashed dividends.
Johnson said not all dividend ETFs are created equal, and energy-sector exposure is of particular concern, given the “meaningful cuts” to blue chips in the energy space. “Every eye is on ExxonMobil now,” he said.
But he added that most of the core dividend ETFs do not have enough sector exposure to energy for the cuts within the sector to be a serious red flag for ETF investors. Vanguard’s VIG has 1 percent exposure, while ProShares NOBL ETF has 3.8 percent exposure,
“If the energy sector is 1 percent of a high-quality dividend ETF, it won’t move the needle,” Johnson said. “And it would have to be much greater than 6 or 7 percent also.”