Even as markets have been relatively calm as of late, investors should be prepared for volatility to return, as I wrote recently. Not surprisingly, then, the search for quality income, which can provide at least some return when markets are volatile, continues. There is one area to consider as a potential investment opportunity this year—dividend growth stocks.
Dividend growth stocks are, as the name implies, companies that generally have a history of consistently growing their dividends. This can set them apart from other dividend stocks, which may provide a more regular—and sometimes more attractive—dividend.
It is important to remember that not all dividend stocks are created equally. There are some conditions—and clear distinctions—that may set dividend growers apart from other dividend stocks in today’s market.
After years of investors chasing the highest yielding stocks, many classic defensive sectors—utilities and telecom, for example—have gotten expensive. In contrast, dividend growth stocks, primarily from cyclical sectors like technology, tend to be higher quality and less expensive than those higher yielders. These high quality companies tend to have stronger balance sheets, lower levels of debt, better earnings growth and higher free cash flow which allows them to grow their dividends year after year.
Appeal of dividends in the late stages of a bull market
As the U.S. bull market gets long in the tooth and earnings have disappointed, some shareholder friendly policies have slowed—namely M&A activity and share buybacks. A company’s commitment to paying a dividend has remained a priority and those growing their dividends are likely to continue to attract investor attention.
The continuing low rate environment
In this historically low interest rate environment in the U.S., stocks have been yielding more bonds. We looked at data between 1978 and 2014 to find that dividend payers in the S&P 500 Index have historically outperformed non-dividend payers over the long term and have done so with less volatility. Admittedly, during the aggressive quantitative easing measures by the Fed over the past few years, high yielding dividend stocks have done quite well. Now, as many investors worry about a global growth slowdown, rising rates and higher volatility in U.S. equity markets, dividend growers offer potential opportunities due to their healthy balance sheets, as well as better valuations, and lower volatility.
But rates will continue normalizing
Another important difference is how they react in a rising rate environment, given rates are likely to continue normalizing with the Fed possibly hiking rates twice this year. Stocks with a history of consistently growing their dividends have historically tended to perform well and exhibit less volatility in a rising rate environment, while high yielding dividends, often considered “bond-like proxies,” have tended to be more vulnerable (due to their high debt levels) and have historically followed bond performance when rates rise.
Taken together, these four themes can make dividend stocks look appealing, particularly dividend growers. Investors looking to manage volatility with quality dividend growing companies may want to consider DGRO, the iShares Core Dividend Growth ETF.
Heidi Richardson is Head of Investment Strategy for U.S. iShares.