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Equities

Why dividend growth?

David S. Park
Portfolio Manager and Director of Research, Co-Head of Santa Barbara Asset Management
David A. Chalupnik
Head of U.S. Active Equities Portfolio Management, Co-Head of Santa Barbara Asset Management
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As investors prepare for the post-pandemic environment, we believe it is an ideal time to reassess the benefits of dividend growth investing within a diversified portfolio. Dividend growers have historically outperformed non-dividend paying companies, with less volatility. Companies with persistent dividend growth have provided competitive returns during periods of market volatility. Given the low interest rate environment, a dividend growth oriented portfolio may provide attractive income with potential for growth. 

Dividend growth stocks have out performed in various market environments

Dividend growth stocks have provided an attractive combination of earnings and cash flow growth potential, healthy balance sheets and sustainable dividend policies. These stocks have historically offered compelling performance during up-markets and provided a buffer during market drawdowns and volatile environments.

Over the long term, dividend growers and initiators have generated higher returns with less risk, measured by standard deviation, than companies that maintained their dividends, paid no dividend and reduced or eliminated their dividends (Figure 1).

Figure 1: Dividend growth stocks have outperformed with less risk

Additionally, while dividends are not guaranteed and will fluctuate, they have contributed significantly to equity total return over the decades. In fact, from 1930 to 2020, 41% of the annualized total return of the S&P 500® was derived from the payment and reinvestment of dividends, with capital appreciation contributing the rest (Figure 2).

Figure 2: Dividends have been a significant component of total return
 

While dividend investing is a timeless strategy, investors should consider several key attributes combined with today’s market dynamics.

The income produced by dividends may be an essential complement to a strong capital appreciation strategy, as it may limit volatility and contribute to total return over time. Market volatility can cause swings in the price return of a portfolio, but the performance of companies with healthy balance sheets and the financial strength necessary to support dividend growth can help mitigate volatility (Figure 3).

Figure 3: Dividend growers have provided excess returns during market volatility

Dividends can be an important check on corporate governance and financial health

Management teams allocate capital based on a belief that the payoff will provide a positive net present value. A sound capital allocation plan, which includes paying and growing dividends, can indicate a management team’s commitment to their shareholders. Companies are currently sitting on a near record pile of cash and liquid assets, but they are increasingly putting that cash back into the hands of investors in the form of dividends.

A combination of dividend yield and growth may provide optimal outcomes

While dividend-paying stocks have provided compelling long-term performance (see Figure 1), not all dividend stocks are the same. Dividend-paying stocks with a combination of yield and consistent dividend growth can indicate quality, given their ability to balance dividend payments with additional capital reinvestment for future growth initiatives.

A firm’s dividend payout ratio is a key indicator of dividend policy flexibility. Companies earning just enough to pay dividends or paying most of their earnings as dividends may be vulnerable to competitive pressure, as cash flow may be insufficient to support operations. In addition, a company with a high dividend yield, or more importantly, high payout ratios, may be at risk of low growth in the future that could threaten both share price appreciation and dividend growth.

Historically, stocks with the highest payout ratio (Quintile 5) have not been the best long-term performers. Among those companies that paid a dividend over the past 20 years, stocks with medium and medium-high payout ratios (Quintiles 3 and 4) have outperformed.

Figure 4: High corporate cash levels are funding dividend payments
Figure 5: The highest payout ratios don’t make the best performers

Valuations of dividend paying companies remain attractive

The risk-on environment in 2020 resulted in price-to-earnings (P/E) multiples expanding meaningfully for non-dividend paying and speculative companies that in many cases were not yet profitable. Relative to the S&P 500, non-dividend paying companies are trading above their 10-year average, while dividend paying companies are trading below their 10-year average.

Figure 6: Despite higher market valuations, dividend payers remain attractively valued

Dividend growers have performed well after interest rate increases

The Federal Reserve and U.S. government provided extraordinary levels of monetary and fiscal stimulus to help boost the economy in the wake of the COVID-19 pandemic. While the Fed intends to keep the fed funds rate near zero for the foreseeable future, inflation fears have led investors to speculate that the Fed may shift policy sooner than expected. Historically, dividend growers and initiators have outperformed the other cohorts of the S&P 500 after the Fed has increased interest rates.

Figure 7: Dividend growers have provided compelling performance after rate increases

Dividend growers may be an important part of a diversified portfolio

We believe many companies are well positioned to continue increasing their dividends over the long term. After price-to-earnings multiples expanded in 2020 due to declining year-over-year earnings, corporate earnings are expected to re-accelerate meaningfully in 2021, as consensus estimates anticipate double-digit earnings per share growth for the S&P 500.

Companies continue to maintain high levels of cash on their balance sheets, with balances of $2.2 trillion as of 30 Sep 2020 near their highest levels in two decades. Additionally, with equity markets experiencing substantial price-to-earnings multiple expansion in 2019 and 2020, we believe corporate management teams may be inclined to focus more on dividend growth as a means of rewarding shareholders in 2021, as opposed to stock buybacks, given the higher valuations.

Investing in companies with sustainable dividend growth can help augment total returns and reduce volatility while providing a growing income stream. Dividend growth oriented companies have historically participated in up-markets and helped to mitigate risk during periods of heighted volatility and market drawdowns. Ultimately, we believe these characteristics create a compelling reason to consider companies with strong balance sheets and the fundamental strength for future dividend growth as part of a diversified portfolio.

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Endnotes

Dividend Policy Description (Figures 1, 3 and 7) The performance of each group is based on the equal-weighted geometric average of dividend-paying and non-dividend-paying historical S&P 500 stocks, rebalanced monthly. Each stock’s dividend policy is determined on a rolling 12-month basis. For example, a stock is classified as dividend-paying if it paid a cash dividend at any time during the previous 12 months. A stock is reclassified only if its dividend payments change. Dividend growers and initiators include stocks that raised their existing dividend or initiated a new dividend during the preceding 12 months. Dividend cutters or eliminators include stocks that lowered their existing dividend or stopped paying regular dividends during the preceding 12 months. The returns do not reflect the deduction of any fees, expenses or taxes that would reduce performance in an actual client portfolio. Returns for stocks that paid dividends assume reinvestment of all income. The periods shown do not represent the full history of the S&P 500; it is the history maintained by the data source. It is not possible to invest in an index. These groups have been determined by Ned Davis Research, Inc. Further distribution of this information is prohibited without prior permission. Copyright 2021 © Ned Davis Research, Inc. All rights reserved.

Figure 2 Periods greater than one year are annualized. The S&P 500 is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic stock market. The S&P 500 in its present form began on 04 Mar 1957. Prior to the 500 Composite, from 1923 to 1926 S&P used as its first broad market indicator, a composite index of 233 stocks. In 1926, to disseminate market indicator information more frequently, S&P created a more manageable subset of stocks that became known as the S&P 90 Stock Composite Index. Prices for the 500 Composite were linked to the 90 Stock Composite to provide daily records back to 1928 and monthly data back to 31 Dec 1925. Return performance is based on equal-weighted geometric average, computed monthly. Dividend income return is based on the return percentage of all dividend-paying companies in the S&P 500. The returns do not reflect the deduction of any fees, expenses or taxes, and assume reinvestment of all income. Investors cannot invest in an index. Further distribution of this information is prohibited without prior permission. Copyright 2021 © Ned Davis Research, Inc. All rights reserved.

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.

A word on risk

All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Dividend yield is one component of performance and should not be the only consideration for investment. Dividends are not guaranteed and will fluctuate. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.

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