Building a Better Income Portfolio
One of the greatest concerns for income-oriented investors is the possibility that dividends will be cut. The financial crisis showed that traditional metrics, such as a stock’s dividend history and its payout ratio, failed to warn investors of impending dividend cuts. By evaluating stocks based on volatility, however, investors can select securities that are more likely to maintain or improve their dividend rates.
A major challenge for income investors, who are always seeking ways to divine the reliability of dividends, is the sea change in dividend policy over the past 50 years. There has been a long-term decline in the percentage of earnings paid back to investors in the form of dividends, especially when measured by dividend yield (the ratio of dividends to price). A long-term rise in price-to-earnings ratios and a shift in corporate policies regarding dividends have both contributed to the trend, as have changes in the composition of the major indexes. Specifically, technology firms have gained increasing weight in stock indexes in recent decades, and these firms tend to pay lower dividends.
The general shift away from dividends notwithstanding, many firms have a long history of maintaining and increasing dividends. Standard and Poors’ Dividend Aristocrats index provides a well-known list of companies that have at least a 25-year track record of raising dividends every year. Even among these firms, however, there is a real risk that dividends may fall. Pfizer (PFE) and General Electric (GE), two firms that had previously been on the list of Dividend Aristocrats prior to 2009, dramatically reduced their dividends in that year, as did several other firms on the list. In all, ten of the Dividend Aristocrats were removed from the list at the end of 2009, 20% of the total.
Volatility as an additional screen
In research published over the past year, I have used the volatility of a stock, ETF, or portfolio as a key variable in judging the attractiveness of a yield-focused investment strategy. My research has used historical volatility, expected volatility from simulations, and implied volatility from options prices, all of which are closely related, of course. Volatility is considerably persistent through time, and the implied volatility from options prices is a key signal for determining the probability of corporate distress. The higher the implied volatility, the higher the probability of distress.
Along the same lines, the lower the volatility of a stock, the more sustainable should be its dividend. Research confirms that stock risk is significantly related to a firm’s propensity to pay a dividend. Firms with high volatility are less likely to pay a dividend, and vice versa. Firms that become riskier through time are less likely to maintain or raise their dividends. Among the range of possible explanations for this effect is that both corporate managers and the market are aware of the relative risk in future earnings. Higher expected risk is reflected in higher volatility, and managers are more likely to hoard cash (rather than paying dividends) when future earnings are highly uncertain. A related explanation is that a company with high volatility is likely to have a harder time raising money by issuing debt, and thus its management will retain earnings rather than pay or raise dividends. The amount of interest that a company pays when it issues bonds increases with the price of credit default swaps, which themselves become more expensive as volatility increases.
The relationship between volatility and dividend cuts also makes intuitive sense. Companies don’t cut their dividends, in general, until they are in such dire straits that a cut is required, which means the probability of distress is naturally linked to the sustainability of dividends.
Using volatility as a screen for income-paying securities has another very straightforward benefit: it avoids stocks that have substantial yields because their stock prices have plummeted. Yields that are high simply because prices have dropped a great deal often warn that the dividend will soon be cut – the so-called ‘dividend trap.’