SUMMARY
- Dividend investing used to be a form of value investing, but the dividend segment of the market has changed since the financial crisis.
- At the portfolio level, there are several steps investors can take to potentially augment the yield from their dividend-paying equities.
- In general, we believe investors should favor stocks of companies with the ability to sustain – and grow – their dividends over time.
Not so long ago, investing in high-dividend stocks was a form of value investing. A stock’s dividend yield is simply its annual dividend divided by the stock’s current price (yield = dividend/price), so the yield-oriented investor was favoring cheap stocks, even if the focus was more on the numerator of this equation. Since the financial crisis, however, the composition of the dividend segment of the equity market has changed. In general, it now contains more risk and less value.
Consider Exhibit A. We have sorted the 10 economic sectors in the S&P 500 by their dividend yields. We have also included the forward price/earnings (P/E) ratio for each sector. The first table shows data from 2001. The second shows recent valuation levels. There is an interesting juxtaposition of yields and P/E ratios in the two tables. In 2001, four of the five high-dividend-yielding sectors were also cheap based on forward P/E estimates. Recently, the reverse was true, with four of the five higher-yielding sectors being more expensive than the broad market based on P/E.
March 2001 is a relevant date for this analysis, as it came exactly one year after the dot-com market peak and approximately two years prior to the passage of the Jobs and Growth Tax Relief and Reconciliation Act of 2003, which reduced tax rates on qualified dividends to the same level as those on long-term capital gains. In other words, with perfect hindsight, 2001 was a great time to favor high dividend yields; growth stocks were still expensive, and the tax treatment of dividends was about to improve.
One interesting research finding is that if you divide stocks into five quintiles, sorted by dividend yield, it is the second quintile that has performed best over the long term (as shown in Exhibit B). Intuitively, this makes sense. Some of the highest-dividend-yielding stocks get that way because the company’s fundamentals are challenged, leading the market to anticipate a dividend cut. The second quintile of dividend payers is generally viewed as more sustainable. This is partly due to higher debt levels among the higher-yielding stocks. The average debt/EBITDA multiple for the highest-yielding quintile is 3.0x, higher than the average company in the S&P 500.
At the individual security level, we believe most investors are best served by not “reaching for yield.” At the portfolio level, however, there are various steps investors can take to potentially augment the natural yield coming from their favorite stocks. These range from the mundane to the more exotic:
- Buy international stocks: By allocating a portion of their equity exposure to non-U.S. stocks, many investors may see a pickup in yield. For example, the MSCI EAFE Index of developed-market stocks in Europe, Australia and the Far East has a dividend yield of 3.5%, roughly 1.4% more than the S&P 500.
- “Capture” dividends: Depending on a U.S. investor’s holding period, dividend income can be treated as “qualified”1 and taxed at lower rates (currently the same rate as long-term capital gains). The investor can then “roll” the proceeds into another dividend-paying stock to repeat the process. There are transaction costs associated with this strategy, and stock prices often fall by the amount of the dividend payment on the ex-date. But, there is research suggesting this strategy has historically produced market-beating returns.
- Include an allocation to high-yield bonds: High-yield bonds are often viewed as the equity market’s close cousin due to their higher potential for risk and reward. In February 2016, yields on these bonds had reached high single-digit levels. If appropriate, equity investors can supplement their yield requirements with a modest allocation to this asset class, while still retaining ownership of their favorite lower-yielding growth stocks.
(Note: These strategies for enhancing one’s yield come with various risks and tax implications. They should be undertaken with the help of a professional advisor who has expertise in these areas.)
Bottom line: Dividend investing has changed through the years and, as a result, so, too, should investors’ approach to it. In our judgment, investors should focus primarily on the sustainability of a company’s dividends, rather than the sheer size of its dividend yield. More specifically, look at the company’s underlying fundamentals to gauge its ability to maintain – and grow – its dividend payments over time.
1Qualified dividend income (QDI) is dividend income to which long-term capital gains tax rates are applied (as opposed to higher regular income tax rates). To qualify, the dividends must be paid by an American company or a qualifying foreign company and must not be listed with the IRS as dividends that do not qualify. In addition, the required dividend holding period must have been met.
The S&P 500 Index is a widely used measure of broad U.S. stock market performance. The MSCI EAFE Index is designed to measure the performance of developed equity markets outside of the U.S. and Canada. Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage. It is not possible to invest directly in an index.
About Risk
Investments in equity securities are sensitive to stock market volatility. Equity investing involves risk, including possible loss of principal. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging countries, these risks may be more significant.
Past performance is no guarantee of future results.
About Eaton Vance
Eaton Vance is a leading global asset manager whose history dates to 1924. With offices in North America, Europe, Asia and Australia, Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of providing exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors. For more information about Eaton Vance, visit eatonvance.com.
The views expressed in this Insight are those of Edward J. Perkin and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.
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