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The Case for Using Dividend-Paying Stock in a Yield-Starved Market

The Case for Using Dividend-Paying Stock in a Yield-Starved Market

As we look to the second half of 2021 and take an assessment of the markets one year after the post-pandemic recovery began, it’s frankly difficult to feel anything but extremely relieved and grateful that global markets faithfully marched onward through human tragedy, political turmoil, and the Aaron Rodgers pseudo-holdout that followed a second straight defeat in the NFC title game. Clearly, the market has been more like Tom Brady than Kirk Cousins, continuing to win even though the run has left both Brady and the U.S. stock market’s bull run a bit long in the tooth, but still hard to bet against.

However, as we turn the page on the first half of 2021 and look ahead to 2022, it’s hard to ignore valuations and worry that, like the Minnesota Vikings, money put to work here and now may give us a Kirk Cousins-like vibe sooner rather than later, meaning that we run the risk of overpaying for expectations that may be beyond our grasp or control. In short, valuations matter, and we shouldn’t give stocks or our quarterback a blank check.

But the core issue facing investors should rarely, if ever, be whether to invest, but where to continue to invest, or how to properly allocate their investments. That seems even more important than ever when we look at the following relative performance metrics over the past 12 months (August through July), based on the total return of popular ETFs tracking the following indexes:

%

S&P 500

%

NASDAQ 100

%

Russell 2000

%

MSCI EAFE (Developed Markets ex: US)

%

MSCI Emerging Markets

%

Barclays Aggregate U.S. Bond Index

That’s an impressive throttling by all major stock markets versus the bond market! Looking closer, and perhaps not surprisingly, the relative return of various stock markets appear to be inversely related to the dividend yield generated by each respective index. Here is an approximate 12-month trailing yield for each of the ETFs upon which these stock index returns were calculated:

%

S&P 500

%

NASDAQ 100

%

Russell 2000

%

MSCI EAFE

%

MSCI Emerging Markets

I would argue that interest rates played more than a minor role in the relationship between valuations, dividend yields, and the outperformance of high-valuation/low-dividend-paying (or we could use the oversimplified term “growth”) versus the lower-valuation/higher-dividend-paying (“value”) stocks over the past year (and going back over the past several years going back to the Great Recession). When interest rates are abnormally low, the “valuation” of the distant future earnings promised by younger, fast-growing companies is distorted by an abnormally low “discounting” of the future earnings, because the discounting is based on prevailing interest rates. Thus, lower interest rates result in a higher present value calculated for companies that promise massive earnings in the more distant future. 

So what happens should interest rates rise, or even rise dramatically? That would tend to have a more negative effect on the valuations of companies with future projected earnings streams that are more back-end-loaded (meaning the bulk of the future earnings are still several years out from today). We’ve seen this play out in the Russell 2000 and the Nasdaq on trading days when interest rates climb on robust economic data (e.g., a strong employment report), often resulting in considerable rotation out of the growth stocks and into “safer,” or “blue chip” stocks that have lower valuations and, quite often, pay dividends out of the company earnings on a regular basis.

Therefore, while rising interest rates are a substantial risk to bond holdings and, arguably, growth stocks that have dramatically outperformed in recent years, the allure of dividend-paying stocks appears rational from both a risk management and a valuation perspective going forward. This volatility (risk management) and return proposition have always been true, but relative underperformance of dividend payers in recent years may increase the odds that dividend payers will enjoy a more profound comparative risk/return profile going forward.

A study by Ned Davis Research and Hartford Funds compared the relative average annual returns and volatility (measured by the standard deviation of returns) of dividend payers in the S&P 500 versus those companies in the S&P 500 that did not pay a dividend. The study examined return data over a very long period: March 31, 1972, to December 31, 2019. It was discovered the dividend payers enjoyed average annual total returns of 12.9%, which was a dramatic outperformance compared to the average annual total return of 8.6% by S&P 500 component companies that did not pay dividends. The relative volatility characteristics of the dividend payers versus the non-dividend payers were equally profound. The average standard deviation over the study period for the dividend-paying component companies of the S&P 500 averaged 15.6% versus a staggering 24.3% average standard deviation for the non-dividend-paying component companies! The upshot is undeniable: Dividend-paying stocks provided both superior returns and lower risk for their investors, a proverbial best of both worlds.

We also want to share some additional points for those investors who want to harvest some (if not all) of the income from their portfolios: Where else but dividend-paying stocks are you going to find yield today, tomorrow and in the years to come? While the potential for rising bond yields in the future increases the potential that bonds may one day again provide a meaningful income stream for investors, this would very much come at the expense of bonds that have already been issued. In other words, bonds carry interest rate risk, and the further out the maturity for the bond, the higher the interest rate risk. Moreover, bonds also carry substantial inflation risk, meaning that the risk that rising prices will reduce the value of the interest stream (coupons) paid by bonds and also the purchasing power of the principal that is promised to the investor when the bond matures. While stocks, even dividend-paying stocks, carry some interest rate risk and also inflation risk, stocks and particularly dividend-paying stocks have distinct advantages. For one, companies can, to varying extents, pass rising costs of doing business on to their customers. Similarly, dividend-paying companies can increase their dividends over time, while most bonds pay fixed sums of regular interest.

Accordingly, for years, the global stock markets have risen in part on their relative attractiveness compared to bonds in a low-interest-rate environment. These stock markets might continue to do so in a rising interest rate environment, and/or in an inflationary environment. However, not all stocks are equally up to the challenges of rising rates and inflation. Those companies with relatively higher current earnings power and those companies that can increase their income payouts to shareholders should be better positioned to weather either, or both, storms and, therefore, we believe that they can play a very important role in investors’ portfolios going forward.

Stan Farmer, CFP®, J.D. 

DISCLOSURES
Walkner Condon Financial Advisors is a registered investment advisor with the SEC and the opinions expressed by Walkner Condon Financial Advisors and its advisors in this article are their own. All statements and opinions expressed are based upon information considered reliable although it should not be relied upon as such. Any statements or opinions are subject to change without notice.

Information presented in this article is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed.  

Information in this article does not take into account your specific situation or objectives and is not intended as recommendations appropriate for any individual. Readers are encouraged to seek advice from a qualified tax, legal, or investment advisor to determine whether any information presented may be suitable for their specific situation. Past performance is not indicative of future performance.

Investment Concepts: Keeping a Healthy Balance

Investment Concepts: Keeping a Healthy Balance

The aims of a diversified portfolio and how it works can be difficult for many investors to understand and in particular a concept that often trips up investors is the concept of “rebalancing”. Rebalancing generally means selling stocks while they are going up and buying them when they are going down.

The first goal of rebalancing is to ensure that investors are not taking more risk than they should or are comfortable with.

For instance, a $10,000 simple portfolio invested in half US stocks and half bonds illustrates this most clearly. If the investment started in January 1987 and was left untouched until the end of 2019, it would’ve ended up as approximately 79% stocks and 21% bonds: meaning that it would have been more risky than an investor originally intended. By rebalancing, that portfolio would stay in line with the targets and give the investor the protection they thought they were getting for down markets. As of writing on March 19, a 50/50 (using VT for the total stock market and BND for the bond portion) portfolio on January 1 would be down only 14.6% versus 21.3% for an unrebalanced balanced portfolio (and 26.2% for an all stock market portfolio) year-to-date.  

Rebalancing then provides insurance on the downside: if disciplined, investors will lose less money when the market goes down. However, there is a less remarked upon side to rebalancing: it means the portfolio potentially will recover more quickly.  

To turn back to the two most recent market downturns (that of 08-09 and 00-02), a 50/50 diversified portfolio returns to flat much more quickly than one without rebalancing. For a non-rebalanced 50/50 portfolio first invested in 1987, the portfolio would have a “drawdown” (or decline off of its peak) of 33.96% in February 2009. The portfolio would recover to its original levels in January 2011. If the same portfolio were rebalanced quarterly, it’s drawdown would be 26.45% and it would return to it’s previous levels by April of 2010. The recovery time for a similar portfolio that was first invested in January 1987 and rebalanced quarterly during the bear market of 2000-2002 would’ve been 12 months less (November 2003 versus November 2004 for an unrebalanced portfolio). 

The case for rebalancing can be made in a variety of ways on paper, but putting the rebalancing in practice can be tricky, taking into account the tax ramifications (this is particularly tricky for US expat clients as they have to take into account tax rules both in the United States and abroad) and the varying time horizons for the variety of cash needs required. However, those who haven’t prepared their portfolio in the face of a downturn by rebalancing, can, hopefully, improve their recovery time by turning to a financial advisor who takes into account their individual challenges but still maintains the discipline needed.

Keith Poniewaz

 

Disclosure note: These securities mentioned were meant to be illustrative in nature only and were not meant to be advice or an inducement for someone to purchase it. You should consider your own personal situation and expertise of a trusted advisor before you implement any investment strategy. The rates of return quoted here are thought to be reliable, but there is no guarantee that they are correct. Again, it’s the premise we are trying to show rather than the actual numbers.