Today's uncertain macro backdrop has many investors steering clear of stocks, and in a world of heightened volatility and ongoing global concerns, few would disagree that a dose of caution is warranted. Moreover, the combination of high sovereign debt levels and increasing austerity measures is keeping a lid on global growth rates.
In a world of low growth, dividend-paying stocks actually possess two attributes that make them especially attractive.
First, they offer an income stream that is quite compelling relative to current fixed-income rates. Second, companies that pay dividends typically have better business models, stronger balance sheets and a higher degree of confidence in their long-term growth capabilities-all characteristics that help these companies' stocks outperform in difficult and volatile times.
In fact, a look at past bear markets reveals that dividend-paying stocks have declined, on average, about half as much as those that do not pay dividends.
But dividend payers offer more than downside protection. Historically, they have outperformed in bull markets as well, affording investors over 3% more per year, on average, during the last 10 U.S. bull markets. In today's highly volatile marketplace, dividend payers have been performing strongly relative to non-dividend payers, as investors appear to be placing a higher value on the downside protection historically afforded by dividends.
One important point is that in the midst of the current-day volatility, correlations among stocks are at an all-time high.
In other words, the market is treating all stocks equally, focusing more on the macroeconomic backdrop than on individual company fundamentals. This can actually create an opportunity for investors to increase the quality of their portfolios.
Coming out of this period, as correlations return to normal, these investors should be poised to benefit as the fundamentals become more important and these high-quality, low-volatility, dividend-paying stocks are priced accordingly.
POSITIVE PAYOUT TRENDS
Over the past year, companies have been returning capital to shareholders through both dividends and share buyback programs.
Some have used excess cash to reduce debt on their balance sheets, also a favorable sign. A look at share prices reveals that the market has been rewarding those companies that are most active in returning capital and strengthening their balance sheets by reducing debt, while simultaneously looking unfavorably upon those that continue to sit on cash.
Because companies are running much leaner and more efficiently than they have in the past, this trend appears likely to continue. As such, shareholders can expect to see meaningful income growth from these companies in the future. Some investors worry that company earnings, after posting record-setting growth for several quarters, are due to nosedive, impacting dividend payments.
But importantly, earnings are only one measure of a company's financial fortitude.
Even amid a moderating growth rate in earnings, U.S. corporate balance sheets are cash-rich and stronger than ever. Currently, the 30% average payout ratio of companies in the U.S. is about half its historic average. Going forward, a return to more "normal" payout ratios can translate into an opportunity for investors to collect even higher levels of current income.
The fact is, fixed-income rates are at historic lows, meaning income-starved investors are going to have to cast a wider net in their search for yield. Lest we forget, the benchmark 10-year Treasury yield, after dropping as low as 1.72% in September, is still trading in the area of 2%. Many corporate bond yields are similarly dismal. Meanwhile, the yield on the S&P 500 Index, at 2.20%, is not too shabby when you consider the most important distinction between bond and equity income-specifically, equity income grows over time. Bonds, as "fixed income" instruments, do not offer the type of income growth potential that can be achieved with equities.
Of course, at the company level, too high of a yield can be a warning sign. It can indicate a company is paying out an unsustainably high level of its earnings as dividends; or it can mean the share price is low and the company may have little prospect for growth.
This is why yield alone shouldn't be an indicator of dividend health and why fundamental research is key to identifying value in today's equity markets.
Our experience with dividend-paying companies, especially the past 10 years, has cemented our view that investing in financially sound, low cost-producing industries is an important strategy for limiting losses in weak economic environments. To that end, we meet regularly with the executive management teams of the companies in which we invest. This helps us identify those industries in which we want to allocate assets and, in turn, allows us to find the best companies within those industries.
We view ourselves as investment partners with these management teams, tracking the company's capital structure, project funding and performance over time.
We tend to be patient holders of company shares. As long as the company continues to deliver on expectations, its core businesses are healthy and dividends persist as a main priority, we will hold the company in our portfolio.
In the current environment we prefer dividend payers that are U.S.-based, are exhibiting strong growth, have globally diverse revenue streams and have offered excellent dividend growth and sustainability over time. These companies are typically operating in the lowest quartile of production cost and are industry leaders that have the advantage of being able to market top-selling brands.
We also tend to focus on less cyclical companies and are more committed to firms that have proved they can do relatively well no matter where we are in an economic cycle.
While a U.S. recovery is an inevitable part of the cycle longer-term, investors need to prepare for a slow crawl rather than a sprint toward expansion.
Companies have rationalized their operations, but spare capacity remains in many industries. Therefore, incremental demand can be met by existing labor and machinery, which means new hiring may be slow, leaving unemployment stubbornly high and capital spending more muted than in past recessions.
Against this backdrop, investors are wise to seek out companies with solid franchises that are in a position to meet real, growing demand for their services. We also believe it is important to be patient with management teams that have a proven ability to deliver on their strategies year in and year out.
By focusing on companies with healthy balance sheets and a commitment to increasing their dividends, investors can sleep a bit more soundly, while also collecting a growing stream of income-which is no small achievement at a time when income is increasingly difficult to come by.
Robert Shearer and Kathleen Anderson are portfolio managers of the BlackRock Equity Dividend Fund.
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