When it comes to equity income investing, there are generally two broad schools of thought: The first seeks out those stocks paying the highest dividend yields. The second focuses on healthy yields (albeit not the highest) with the potential to grow income over time (aka “dividend growers”).
In the low-interest-rate, income-starved world of the past several years, those high yielders drew a lot of interest—and assets—so much so that they are now quite expensive. You could also argue they are quite risky today. Indeed, at current prices, there’s little room for appreciation. These high yielders are also known as “bond market proxies,” because they are highly correlated to and behave much like fixed income assets. That means they are more likely to decline in value as interest rates rise. (And we all know the Federal Reserve has its sights on raising rates.)
Meanwhile, the dividend growers were largely ignored in the low-interest-rate regime. They were not sought after and bid up in price like their higher-yielding counterparts. And that makes their price tags potentially more attractive now.
The charts below show how the bond proxies are trading at valuations that are more than one standard deviation higher than their historic averages. The high dividend growers are just the opposite: They are trading one standard deviation lower, or cheaper, than they usually do.
The appeal increases when you consider that dividend-growth companies tend to be of higher quality and lower volatility than the broader stock market. We define that this way:
1. On quality: If you think about it, who has the means to grow a dividend? It is generally businesses with solid balance sheets and a lot of free cash flow—in other words, quality franchises.
2. On volatility: In our experience, a company’s commitment to paying a dividend has been shown to provide a certain discipline, and that has made for greater resilience in down markets. No corporate executive wants to cut a dividend, so these tend to be well-run companies with a capacity to weather up and down markets. Truth be told, we would be more worried about companies paying a dividend so high that it is unsustainable.
When it comes down to it, in a stock market that is feeling more uncertain and volatile than it has in several years, and when income vehicles are priced at a premium, there’s a certain wisdom (or at least well-studied prudence) in considering a slightly lower dividend in exchange for the potential for greater stability and long-term return.
This is a guest post from Tony DeSpirito and the team at the BlackRock Equity Dividend Fund, where Tony is a portfolio manager.