- In a lower interest rate environment where bond yields are also depressed, the quest for yield becomes more pronounced, and stocks are well-positioned to provide it.
- An actively managed and diversified approach can find attractive dividend profiles in different sectors.
- We believe maintaining a steady and growing dividend stream is appropriate for the current market environment.
Slower global growth and uncertainty surrounding international trade contributed to a shift in monetary policy in 2019, as the Fed reversed its tightening regime and investors bought up relatively safer Treasury bonds, pushing down yields. The length of the current bull market, now approaching its 11th year, combined with yield curve inversions we saw in 2019, has heightened concerns of a recession. It is a good time to examine the role of income and the value of an active approach to dividend investing.
In a lower interest rate environment where bond yields are also depressed, the quest for yield becomes more pronounced, and stocks are well-positioned to provide it (Exhibit 1). The need for a multifaceted dividend approach also becomes more pronounced. We believe the push for yield, sustained by demographic changes, low rates and late-cycle volatility, will reward a diversified dividend strategy that emphasizes not only attractive current yield but also dividend growth across the sector spectrum.
Exhibit 1: Stocks Offer Relatively Competitive Income Source
The quest for yield is pronounced given that income remains an important component of total return, and with the baby boomer generation in prime retirement age, the need for income will only grow. In the U.S., 76 million baby boomers face a $1 trillion funding gap in pensions, health care and other benefits. A strategy that seeks out companies with the ability to compound dividends over the long term should be able to help meet this gap over long periods.
Dividend growers have a history of being rewarded by the market over time (Exhibit 2). A look at the returns of S&P 500 stocks sorted by dividend policy shows that all dividend payers tend to outperform the broad market. It also shows it is equally important to avoid companies cutting or eliminating their dividends. The dividend environment remains supportive and the number of dividend payers raising their dividends remains high: for the 12 months ended December 31, 2019, 84% of the 423 dividend-paying stocks in the S&P 500 Index had increased their payouts, according to FactSet.
Exhibit 2: Returns of Dividend Stocks by Dividend Policy
A Diversified Approach
The foundation of a successful actively managed dividend strategy is a focus on companies with not only attractive current dividend yields, but also rich histories of dividend increases. In terms of current yield, these are typically found in more defensive sectors such as utilities and consumer staples, or in income-focused areas such as real estate. A more diversified approach, however, can find attractive dividend profiles in different sectors (Exhibit 3). In the low-yielding health care sector, for example, we seek a balance of current yield — our holdings have a higher average current yield than the S&P 500 — and dividend growth. Holdings with lower current yields, such as managed care provider UnitedHealth Group and pet and livestock medicine and vaccinations company Zoetis, have exhibited strong dividend growth, increasing their dividends by over 200% and 100%, respectively, over the last five years.
Exhibit 3: ClearBridge Dividend Strategy 5-Year Dividend Growth Rates by Sector (Weighted Average)
The Value of Relative Growth in Defensive Sectors
In an actively managed dividend portfolio, an emphasis on growth can also extend to high-yielding areas such as the utilities sector. Utilities stocks are mainstays of most dividend strategies: facing low elasticities of demand, utilities companies enjoy consistent revenue streams and typically pay large steady dividends to shareholders. Among utilities, however, our holdings achieve a higher dividend growth rate than the market while still collecting a sound current yield. The average three- and five-year dividend growth rates among utilities holdings are three and four percentage points higher, respectively, than the broad market sector (Exhibit 4).
Exhibit 4: Relative Dividend Yield and Growth in Utilities Sector
This relative dividend growth advantage stems from our preference for utilities stocks that feature a balance of defensive and growth characteristics. For example, NextEra Energy, a hybrid utility encompassing a regulated utility in Florida and an unregulated power generation business, has paid a dividend continuously since 1947 and raised its dividend for 25 consecutive years. NextEra’s great earnings and dividend growth is explained by its successful business model. On the utility side, operational efficiencies have helped keep customer rates affordable and improved the company’s relations with the state regulators, allowing NextEra to earn premium returns in the state while making sizeable investments into the grid. On the generation business side, NextEra was an early mover into a nascent renewable market several years ago, and now is among the largest renewable project developers and capacity owners in the country. Its large scale and expertise have helped it maintain its competitive advantage even with increased competition.
Finding Current Income in Growth Sectors
Further, in an actively managed dividend portfolio, an approach to income does not preclude finding attractive income opportunities in traditional growth-oriented sectors such as information technology (IT). The IT sector is usually not a major contributor to income, as many IT companies offer low or no current income. Yet we are finding examples of high growth and high current yield in the IT sector, for instance in global semiconductor company Texas Instruments, which has paid an uninterrupted dividend since 1962 and has raised it annually for the past 15 years. Texas Instruments is relatively high yielding at 2.55% and is among the top IT dividend growers in the portfolio, with three- and five-year dividend growth rates of 25.6% and 20.0%, respectively. Our IT holdings have paid dividends consecutively for 20 years on average and have raised them annually an average of 10 years consecutively. They also have achieved strong dividend growth rates, averaging 15% over the past five years.
The Value of Dividend Payers
In sum, as the quest for income has become elevated and should remain so as we return to a period of lower interest rates, dividend-paying companies will become increasingly valuable. In our view, companies with healthy balance sheets, consistent cash flows that provide plenty of capital to effectively operate their business, and modest payout ratios remain in a good position to sustain dividend increases. We believe an actively managed dividend portfolio that builds diversified exposure to them, maintaining both attractive income levels and strong growth characteristics, is a sound approach in the current environment.