- U.S. equities declined in the fourth quarter, while stock selection in the portfolio helped it show more resilience than the market.
- Our portfolio companies are in good fundamental shape, their valuations are the best they have been in years and we believe their dividends should continue to grow nicely over time.
- Over the long term, Dividend Strategy has provided competitive performance by participating in up markets and outperforming in down markets.
Market Overview and Outlook
What a difference a quarter makes. Through the third quarter the S&P 500 was up 10.5% while our portfolios were up mid-single digits. The strong S&P performance was driven primarily by a handful of high growth stocks, a topic we discussed in our second quarter letter. This narrow FAANG-driven market was not particularly favorable for dividend portfolios as the majority of the FAANG stocks (Facebook, Apple, Amazon, Netflix, Google) do not pay dividends and thus are not candidates for investment.
In the fourth quarter the market declined substantially to finish the year down 4.4%. Dividend Strategy also declined during the quarter, but far less than the broader market. While the market was down 13.5% in the quarter, the portfolio was down around two-thirds as much. This is in line with how we would expect the portfolio to perform in a down market.
As we recap the past year’s performance and provide an outlook for 2019, it seems a good time to provide a quick reminder of what we are trying to achieve with the portfolio.
At the highest level, we have three objectives:
- Attractive upfront yield, typically 50–100 basis points (bps) higher than the yield of the S&P 500 Index. The Strategy currently yields about 75 bps more than the S&P 500.
- The powerful compounding effect of dividend growth. Since inception, portfolio holdings have compounded dividends at about 9%. Over the last two years dividend growth has averaged approximately 11%.
- A conservative, diversified, low-risk portfolio. The combination of stock selection and portfolio construction looks to help protect capital in down markets. Over the last 10 years downside capture has been 75%.1
Our holistic approach to dividend investing, emphasizing dividend growth while delivering current yield, results in a broadly diversified portfolio. This differs from more traditional approaches to dividend investing, which tend to focus on areas like utilities, telecom companies and pharmaceuticals. This diversification mitigates risk and volatility in the portfolio and over the long-term should enable better total return as it allows us to invest in higher growth areas of the economy — not just the “bond proxies” that come to mind when people think about dividend payers.
During the fourth quarter our outperformance relative to the market came primarily from our stock selection, not our asset allocation. In other words, we outperformed the market not because we were hiding out in utilities, staples and health care (three sectors that were down far less than averages), but because even though we were well-represented in most major sectors, our individual investments in those sectors meaningfully outperformed their peers. So, while we were overweight energy (the worst-performing sector in the S&P), energy was a positive relative contributor because our average energy stock outperformed the benchmark sector. Within energy we have focused on energy infrastructure. These pipeline companies generate stable, predictable cash flow from their existing assets significant growth due to the shale-driven increase in U.S. energy production. Indeed, the main sector where our holdings underperformed their peers was in utilities, where our higher growth, more dynamic companies underperformed their stodgier peers.
Over the long term, the portfolio has provided competitive performance by participating in up markets and outperforming in down markets. In heady bull markets we should up be up nicely, but often not as much as more aggressive portfolios. In down markets, like the fourth quarter, we tend to hold up better owing to the quality of our companies, the support provided by dividend yields and our emphasis on companies and industries with less cyclicality and economic sensitivity.
This pattern of performance has played out consistently over the last 11 years — a period that encompasses both the financial crisis and the ensuing recovery. And, again, this pattern can be seen in 2018, a year that started with a bang and ended with a rout.
"In 2018 our portfolio companies boosted their dividends by 11% on average."
The message that we would like to drive home is that equity investing in general and dividend-focused investing in particular are all about the long term. In any one quarter or any one year, the market can be highly unpredictable. But a portfolio of high-quality dividend stocks should see its holdings grow dividends each year and over time that compounding is powerful.
As we look ahead to 2019 we see a world and markets with big positives and big questions. The positives: the U.S. economy is still performing well, interest rates are still low by historical standards and valuations are reasonable given the recent pullback. The questions: will the U.S. economy remain robust, will central bank policies prove disruptive, will global trade issues be resolved, and what will happen on the political front (both domestically and globally)?
We do not know how these dynamics will play out, and many of the factors that drive the markets are beyond our control. We do have control of which securities we choose to own and we feel strongly about our holdings. Our portfolio companies are in good fundamental shape, their valuations are the best they have been in years and we believe their dividends should continue to grow nicely over time. If the market recovers sharply we would expect to participate. If the volatility continues, we expect to navigate it better than most. Either way, we think Dividend Strategy is well-positioned.
The ClearBridge Dividend Strategy outperformed its S&P 500 Index benchmark during the fourth quarter. On an absolute basis, the Strategy had losses across the 11 sectors in which it was invested for the quarter (out of 11 sectors total). The least negative contributions to Strategy performance came from the health care, utilities, real estate and consumer staples sectors, while the main detractors came from the financials and information technology (IT) sectors.
On a relative basis, both stock selection and sector allocation added to performance for the quarter. In particular, stock selection in the health care, energy and consumer discretionary sectors helped relative returns. An overweight to consumer staples and an underweight to IT also boosted relative results. Meanwhile, stock selection in the utilities sector dampened relative performance, as did an underweight to health care and an overweight to energy.
On an individual stock basis, the largest contributors were Procter & Gamble, Merck, American Tower, McCormick and McDonald’s. Positions in Apple, Schlumberger, Blackstone, Raytheon and Home Depot were the greatest detractors from absolute returns in the quarter.
During the quarter, we established positions in Vulcan Materials in the materials sector, American International Group in the financials sector and Cisco in the IT sector. We closed positions in Weyerhaeuser in the real estate sector, Brighthouse Financial in the financials sector and McCormick in the consumer staples sector.