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Commentary

Dividend Strategy

Third Quarter 2018

Key Takeaways
  • During the quarter the portfolio benefited from strong performance in the industrials, health care and IT sectors.
  • Dividends today are a far more efficient mechanism for returning value to shareholders than they have been in decades.
  • Growing cash flow is the only way to offset rising interest rates, so as the rate cycle progresses, a portfolio of high-quality dividend growers can help to offset the ravages of higher interest rates.
Market Overview and Outlook

The third quarter was a good one for Dividend Strategy and the stock market overall. Information technology (IT), health care, industrials and consumer discretionary stocks were all up around 10% or more in the market. Growth stocks continued to outperform, but by a much smaller margin than in the first half of the year.

It has been an excellent year for dividend growth. In the past year, dividends have increased 8%, up from 7% the year before. With its focus on dividend growers, the ClearBridge Dividend Strategy is well positioned to benefit from this trend.

Economic activity continues to be brisk. Second-quarter GDP showed the U.S. economy growing at 4.2%, the highest level since 2014. Unemployment is a historically low 3.9%, while jobless claims reached the lowest rate in half a century. The economy’s strength has enabled the Federal Reserve to continue raising interest rates. The Fed has raised rates four times in the last 12 months and expects to raise rates three more times in 2019.

Given the broad significance of rising interest rates, we feel it’s worth revisiting a topic we have covered in previous letters. As interest rates have risen, some investors have asked if dividend payers are still a good place to be. They see bonds offering better rates than they did a year ago and wonder if the time for dividends has passed. And, indeed, as interest rates have increased in the early part of this rate cycle, dividend-paying stocks have experienced turbulence. Dividend payers often underperform in the early part of a rising rate cycle. But as the cycle matures, dividend payers and especially dividend growers tend to more than recoup that initial underperformance. For reference we revisit a chart that we included in our first quarter letter (Exhibit 1).

 

Exhibit 1: Performance of Dividend Stocks Following Fed Rate Hikes

Copyright 2016 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. Average performance after all rate hikes since 1972. Dates of rate hikes: 1/15/73, 8/31/80, 4/9/84, 9/4/87, 2/4/94, 3/25/97, 6/30/99 and 6/30/04.

 

While there is no guarantee that the past is prologue in this interest rate cycle, there is good reason why dividend payers hold up well. Growing cash flow is the only way to offset rising interest rates. So as the rate cycle progresses, a portfolio of high-quality dividend growers can help to offset the ravages of higher interest rates.

The healthy U.S. economy has driven strong corporate earnings in 2018, supporting robust dividend growth. Second quarter earnings reports released over the summer showed the third-highest growth rate since 2010.1 Both the economy and corporate earnings reflect, in part, the benefit of the recent corporate tax cut. With lower tax bills, companies have more cash to distribute to shareholders.

The recent tax cut builds on a foundation that was laid in 2003, when the tax rate on qualified dividends was reduced to 15%.2 This was a watershed event for dividend investors as it meaningfully reduced the drag of double taxation.3 The recent corporate tax cuts further reduce the burden of double taxation, making dividends today a far more efficient mechanism for returning value to shareholders than they have been in decades. A dollar’s worth of pretax income today generates up to 67 cents in dividend value, up dramatically compared to prior tax regimes (Exhibit 2).

 

Exhibit 2: Dividends Becoming Increasingly Attractive

Source: ClearBridge Investments. Pre-2003 assumes corporate tax rate of 35% and maximum marginal tax rate of 39.6%. 2003-2017 assumes corporate tax rate of 35% and qualified dividend  tax rate of 15%. 2018 assumes corporate tax rate of 21% and qualified dividend tax rate of 15% for individuals earning under $400,000 and households earning under $450,000. For simplicity, table assumes a 100% payout ratio.

 

During the quarter the portfolio benefited from strong performance in the industrials, health care and IT sectors. Union Pacific hit all-time highs as it announced it would implement precision scheduled railroading, an operating strategy that should lower operating expenses and boost profits. As an entirely domestic railroad company, Union Pacific has benefited significantly from tax cuts; it has raised its dividend by 20% in the last 12 months. In health care, Pfizer, Merck and Johnson & Johnson were all up double digits, lifted by: strong earnings, steady product approvals, positive clinical catalysts, good pipeline delivery and more benign regulatory rhetoric around drug pricing. In the IT sector, Visa, Mastercard and Microsoft all delivered nice performance for the portfolio. These companies exemplify our preference for stocks with recurring revenues, strong margins and returns and prodigious free cash flow.

The market has done well thus far in 2018 and the strong economy gives reason for continued optimism. At the same time, the list of risks is as long as it feels trite: rising rates, fiscal deficits, trade wars, regular wars, climate change, political uncertainty, geopolitical fragility — you get the point.

In this period, which we would generously term “interesting times,” we remain steadfast and disciplined. We focus on high-quality companies with relatively less economic sensitivity and the potential to compound earnings and dividends at attractive rates over the long term. Today’s bull market is nine years old and valuations are at cyclical highs. Against such a backdrop, we believe investing in a diversified portfolio of fundamentally strong dividend growers represents a sound course.

Portfolio Highlights

The ClearBridge Dividend Strategy underperformed its S&P 500 Index benchmark during the third quarter. On an absolute basis, the Strategy had gains in nine of the sectors in which it was invested for the quarter (out of 11 sectors total). The main contributors to Strategy performance came from the financials, IT and health care sectors, while the main detractors came from the energy and real estate sectors.

On a relative basis, sector allocation detracted from performance for the quarter. In particular, underweights to the health care and IT sectors and an overweight to the materials sector detracted from relative results. Stock selection in the consumer discretionary and energy sectors also dampened relative returns. Meanwhile, stock selection in the financials and the newly created communication services sector, which expands the telecommunication services sector to include select companies from the consumer discretionary and IT sectors, contributed significantly to relative performance.

On an individual stock basis, the largest detractors were General Motors, Enbridge, Schlumberger, Weyerhaeuser and Anheuser-Busch InBev. Positions in Berkshire Hathaway, Microsoft, Apple, Blackstone and Merck were the greatest contributors to absolute returns in the quarter.

During the quarter, we closed positions in Suncor Energy, in the energy sector, and Lamb Weston and Kimberly-Clark in the consumer staples sector.

Michael Clarfeld, CFA

Portfolio Manager
18 Years experience
12 Years at ClearBridge

Scott Glasser

Co-Chief Investment Officer, Portfolio Manager
27 Years experience
25 Years at ClearBridge

Peter Vanderlee, CFA

Portfolio Manager
19 Years experience
19 Years at ClearBridge

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Related Blog Posts

  • Performance source: Internal. Benchmark source: Standard & Poor’s. Neither ClearBridge Investments LLC nor its information providers are responsible for any damages or losses arising from any use of this information.

  • Past performance is no guarantee of future results.

  • 1

    Source: S&P 500 Index. FactSet Earnings Insight, September 7, 2018.

     

  • 2

    Prior to 2003 dividends were taxed at an individual’s marginal tax rate.

  • 3

    The shareholder is taxed first at the corporate level, as the corporation pays taxes, and then pays additional taxes on the dividends received.