⚡ New: deep dive on high-dividend stocks

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ARTICLE

It Might Finally Be Dividends’ Time To Shine

By Stéphane Renevier

Cover image for It Might Finally Be Dividends’ Time To Shine

This is a new type of analysis: a deep-dive into an individual investment opportunity. Let us know what you think, so we can keep improving going forward.

High-dividend stocks aren’t as exciting as the next commercial spaceline or artificial intelligence company, it’s true. And they haven’t exactly won over investors lately, with analysts only expecting them to grow their dividends by 1.8% a year for the next few years. But they offer more than just stability, income, and attractive risk-adjusted returns as we head into a very uncertain few months: their fortunes could be about to turn too.

Why is now such a good time to invest in high-dividend stocks?

High-dividend stocks have a firm foundation to stand on.

History paints a positive picture of high-dividend stocks.

First, they’ve provided the kind of regular income that makes them a great option for investors looking for stable cash flows. Second, they’ve increased investors’ probability of making money: an almost certain cash-flow in the near term is safer than uncertain capital gains in the long term. And third, they’ve tended to be more defensive and traded at cheaper valuation levels than the broader market: companies paying high dividends tend to be in more mature industries (think financials, utilities, and energy) and less driven by the variations in the business cycle.

Dividend yields are more attractive than bond yields.

The demand for income is strong right now, for a variety of reasons: an aging population, low real yields, pension funds’ need for cash flow, a potential increase in capital gains tax – to name just a few.

And high-dividend stocks are still the best way to scratch that itch. Sure, the gap between the high-dividend stock yields (around 5% in Europe and 3% in the US) and bond yields (around 0.7% in Europe and 2.6% in the US) has narrowed, but it’s still not closed entirely. Consider too that high-dividend stocks offer an extra bonus in the form of capital gains if the company performs well, and they’re arguably a much better choice.

Dividends might be about to climb (and by more than investors think.)

The market is currently seriously bearish on the growth outlook for US stock dividends, pricing in 1.8% annual growth over the next 10 years. For context, annual dividend growth hasn’t fallen below 2.2% a year over a 10-year period since 1948.

That’s surprising given that companies’ fundamentals are generally strong: firms have lots of cash on their balance sheets, limited growth opportunities, and robust free cash-flows (FCF). That puts them in a good position to increase their dividend payout ratios – which are low by historical standards – and their dividend yields. What’s more, profit growth has been firing on all cylinders since the pandemic recovery, and dividend yields typically lag behind, suggesting higher dividends are due in the near future.

And it’s not just that dividends are likely to rise: investor expectations are so low that they’re almost certain to beat them, which could lead to further inflows into high-dividend stocks.

High-dividend stocks are well-equipped to deal with a challenging environment.

High dividend stocks tend to outperform the broader market when interest rates are rising, when inflation is high, and when economic growth slows. In fact, the higher the dividend yield, the greater the protection against slowing economic growth, and the lower the exposure to interest rate and inflation risk.

There’s a simple reason for that: high-dividend stocks earn a bigger portion of their cash in the near future than, say, growth stocks, which are expected to pay their first dividends years down the line (because they’re so focused on profit growth). That means high-dividend stocks are less impacted by a higher discount rate, which mathematically punishes those with distant cash flows more. That makes them a handy choice for your portfolio: they provide an attractive yield like bonds, but they’re threatened much less by higher interest rates.

High-dividend stocks have also historically outperformed the broader market when inflation is high. That’s partly because companies paying generous dividends are in sectors that indirectly benefit from higher inflation – think energy and real estate. After all, more mature companies are better able to pass higher costs on to their customers, while higher inflation makes near-term cash-flows more valuable.

Lastly, dividend stocks have significantly outperformed the broader market in times of stagflation, which is becoming an increasingly likely backdrop over the next few years. This isn’t just a theory either: high-dividend stocks performed well both during the tech bubble burst in 2000 and the global financial crisis, but they would have added most value to your portfolio during the stagflationary environment of the 1970s.

In fact, Goldman Sachs has crunched the numbers and calculated what allocation to high-dividend stocks would’ve improved the risk/reward of a portfolio of stocks and bonds the most. And for most of the 70s and 80s, the optimal allocation would have been 100%. That’s a stark turnaround from the last decade or so, where it wouldn’t have benefited your portfolio at all (barring a period during the pandemic). That makes sense: growth stocks have performed strongly over that period, while bonds provided strong diversification benefits. There’s been no need for high-dividend stocks.

High-dividend stocks are cheap.

Stock returns can be broken down into three components: earnings growth, dividend yield, and a rise in the valuation multiple.

Since the global financial crisis, most returns have been driven by earnings growth and multiple expansion. But valuations are now at all time-highs, and earnings growth is likely to slow down given the upcoming macroeconomic headwinds. By investing in high-dividend stocks, you’re reducing your reliance on valuation and high earnings growth to generate returns, and increasing the probability that you’ll generate positive returns.

Even better, the fact that both US and European high-dividend stocks are trading at a 20% discount to their respective markets gives them an asymmetric profile: they have a buffer if the market falls, but still have room for extra gains from multiple expansion if things pan out. And since many high-dividend stocks are also value stocks, they could profit from an eventual recovery in value stocks versus growth stocks too.

So are high-dividend stocks a win-win?

Unfortunately not. First, they don’t do well in every environment: they underperform the market during strong economic recoveries, when valuation multiples keep expanding, and when investors strongly favor growth stocks over safer ones (like we’ve seen over the past decade).

Second, while high dividend stocks tend to be more defensive than the wider market, they remain a risky asset. So when markets crash, the dividend yield won’t be enough to offset capital losses, and your total returns will be negative. Oh, and their dividend isn’t guaranteed: when a company’s profit margin gets squeezed, its ability to pay dividends is impaired. So don’t mistake them for bonds, which provide some diversification benefits when times are tough.

Third, a high dividend yield isn’t always a good sign: it may be that the payout is unsustainable, or that there aren’t any growth opportunities available. Investors, then, are likely to punish such a “value trap” with a lower multiple (and hence lower stock price), and ultimately erode the benefit of the higher dividend. That’s what’s happened to financials and energy companies since the global financial crisis: their capital gains have been severely capped by punishing multiples, undermining their attractive dividend yields.

As for how to tell the real deals from the phonies, there are a few questions you’ll want to ask yourself:

  • What have the company’s dividends been historically, and what are investors expecting in the future?
  • How sustainable are the company’s dividends?
  • Is the company’s balance sheet healthy, and does it suggest they’ll have the ability to pay future dividends?
  • Does the company have high enough pricing power?
  • Does the company operate in a growing industry or a shrinking one? Cyclical or defensive?
  • How does the company pay back its shareholders – just with dividends, or buybacks too?

How could you profit from high-dividend stocks?

Invest in companies with high and stable dividends.

If your goal is to bring as much diversification and defense to your portfolio as possible, this might be your best approach: it’s the easiest one to implement and has a low turnover.

Simply invest in companies with a high and stable dividend yield, which also tend to be the most defensive ones. Those companies are particularly attractive in Europe right now, since they not only provide an attractive dividend yield, but also tend to be in industries that are poised to perform in the current macro environment.

To identify defensive high dividend stocks, only two characteristics are necessary:

  • A dividend yield of above 3.5%
  • A maximum of one dividend cut over the past 10 years

Here’s a snapshot of the top European companies that fit those criteria, sorted by expected dividend yield:

The SPDR S&P Euro Dividend Aristocrats UCITS ETF (expense ratio: 0.3%, dividend yield: 2.9%) tracks companies with rising or stable dividends for at least 10 consecutive years, and it might be the best expression of this strategy. For US investors, the OShares Europe Quality Dividend ETF (ticker: OEUR, expense ratio: 0.48%) might be a good bet, as it has an exposure to defensive sectors like healthcare, industrials, and consumer staples.

Invest in companies with high and sustainable dividends.

This is a slightly more advanced variation of the above: it looks at current dividend yield, but also how sustainable it is and how strong the company’s balance sheet is. You’ll want to pay attention to the following characteristics:

  • The company’s history of dividend growth. Ideally you want to see stable growth.
  • The FCF in relation to dividends. The higher, the better.
  • Dividend payout ratios that are expected to be below 80% next year. That suggests they’re more likely to be sustainable.
  • A strong balance sheet, with an Altman Z-score above their sector’s bottom quartile.

Companies meeting those criteria will probably have a much higher dividend yield than the market (statistically about 60% higher), and they’ll also probably be much cheaper (expect a discount of at least 20%). Interestingly, history shows that the higher the dividend yield, the cheaper the company.

Here are a few European stocks that meet those criterias (as a starting point – you should hold a basket of at least 5-7 stocks to reduce idiosyncratic risk). They’ve been selected not just for their characteristics previously mentioned, but also to be representative of different countries, industries, and valuation levels.

If you prefer a more passive approach, high-dividend ETFs are a great option. They don’t allow you to customize their often less-than-optimal stock selection criteria, but they are an efficient way to benefit from high-dividend stocks. It’s also worth mentioning that some will actually pay the dividend (“i.e. “distribute”), while others will reinvest them automatically (i.e “accumulate”). Which you choose depends on your preference for cash-flow or capital gains, as well as your income tax bracket: the higher it is, the more incentive to select the latter, as you’ll be taxed on capital gains instead.

European investors should look at the Amundi MSCI Europe High Dividend Factor UCITS (expense ratio: 0.23%, dividend yield: undisclosed), while US investors might want to look at the First Trust STOXX European Select Dividend Index Fund (ticker: FDD, expense ratio: 0.58%, dividend yield: 3.6%) for a high yield and value-oriented option.

Invest in companies with high dividend growth.

Those who want a higher-octane version of the high-dividend approach should focus on dividend growth, rather than yield.

Of course, the trade-off you’re accepting is a higher risk and a lower income for the potential of higher capital gains and future dividends. That might be the right strategy if you’re more bullish on the economy, or if you want a more defensive style of growth investing. Again, this implementation looks particularly appealing in Europe, but it can work in the States too.

To identify high-dividend growth stocks, look at companies that:

  • Have the highest-expected growth in dividends over the next 3 years.
  • Have grown their past dividends by more than their sector median.
  • Have a payout ratio below 100%. That means they’re both sustainable and have room to grow.
  • Have an FCF / dividend ratio above their sector’s bottom quartile.
  • Have a dividend yield above the bottom quartile of their sector.

These stocks won’t necessarily have a higher dividend yield than the market average right now, but their dividends are expected to grow quickly over the next few years – boosting your future income and potentially your capital gains in the process. Unlike high-yield stocks, however, high-growth dividend stocks are unlikely to be trading at a valuation discount.

Here are some stocks that rank well on the screen:

If you’re a US investor looking for passive exposure, you might like the ProShares MSCI Europe Dividend Growers ETF (ticker: EUDV, expense ratio: 0.56%, dividend yield: 1.29%). European investors don’t have an exact equivalent, but the iShares MSCI Europe Quality Dividend UCITS ETF (expense ratio: 0.28%, dividend yield: 4.26%)is the closest to it.

Invest in companies that blend high yields with high growth

We’ve covered both high-dividend yields and high-dividend growth as separate strategies, but you can also invest in a mix of the two. To identify those kinds of companies, look at ones that:

  • Have the highest-expected dividend growth over the next three years.
  • Have grown their dividends at a faster pace than their sector median.
  • Have high dividend yields.

Let’s look at the US stocks Goldman Sachs has applied this screen to:

As for ETFs, there’s none that exactly replicates a blended approach. But you could combine two ETFs to get somewhere close: the Schwab U.S. Dividend Equity ETF (ticker: SCHD, expense ratio: 0.06%, dividend yield: 2.83%) – which focuses on high and sustainable dividends – and the iShares Core Dividend Growth ETF (ticker: DGRO, expense ratio: 0.08%, dividend yield: 1.94%), which centers on growth.

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