As inflationary pressures persist and investors prepare for tighter monetary policy, 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 expectations for an extended period of higher inflation, a dividend growth-oriented portfolio may provide a slight hedge against rising costs while providing an attractive level of income with potential for growth.
Dividend growth stocks have outperformed 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 in 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).
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 2021, 40% 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).
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).
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 and 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 (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.
Valuations of dividend paying companies remain attractive
The risk-on environment of the past few years 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.
Dividend growers have performed well after interest rate increases
The U.S. 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 pandemic. The Fed started tightening monetary policy in late 2021 by tapering monthly bond purchases, and rate hikes are expected to begin in 2022. The U.S. equity markets have performed well in previous tightening cycles (Figure 7).
Historically, dividend growers and initiators have outperformed the other cohorts of the S&P 500 after the Fed has increased interest rates.
With rising interest rates in mind, we believe investors should focus on dividend paying companies supported by positive fundamentals, balance sheet strength, ample free cash flow and management teams committed to sustainable dividend growth. On the contrary, higher yielding sectors with high debt levels might be challenged given their interest rate sensitivity.
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. Fueled by strong earnings growth and the reinstatement of suspended dividend policies from 2020, the S&P 500 experienced 5% growth in dividends per share in 2021. Looking forward, S&P 500 dividends per share are expected to grow by 7% in 2022 with the fastest growth coming from the consumer discretionary, real estate, financials and information technology sectors.
Companies continue to maintain high levels of cash on their balance sheets, with balances of $2.1 trillion as of 30 Sep 2021 near their highest levels in two decades. Additionally, with equity market valuations above their long-term averages, we believe corporate management teams may be inclined to focus more on dividend growth as a means of rewarding shareholders in 2022, 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. The combination of strong capital flexibility and growing dividend payments may help mitigate inflationary pressures and the impact of higher interest rates.
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.
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 2022 © 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 2022 © 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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