Dividend stocks: a source of value in today’s richly valued market

Today’s headlines are as unnerving as ever, but so far this year, neither natural disasters nor geopolitical events have had more than a temporary impact on financial markets. The record highs that global stocks have reached, however, rest on valuations that are rich by historical standards.

Those valuations have been supported by ultralow interest rates, courtesy of the world’s central banks, which are now looking to engineer a more normal interest-rate environment. Many fund managers have recently been seeking to provide downside protection by reducing equity exposure and increasing their portfolios' allocations to cash, worried that the market’s buoyancy and remarkable lack of volatility will be tested.

For investors, we know that equity exposure is important for long-term growth potential. But how should they be positioned for an equity environment that appears likely to be more volatile than in the recent past?

One approach in uncertain times is to insist on payment up front—in other words, to invest in stocks that have historically provided sustainable and growing dividends. Over long periods, stocks that pay dividends have outperformed stocks that don’t, and stocks that have grown dividends have performed even better those that don't. What’s more, stocks that have paid stable or growing dividends have generated substantially less volatility than the broader market as measured by standard deviation, helping to protect capital during market downturns.¹

To begin with the obvious, the dividend portion of their total return is paid to investors in cash, which can be reinvested or used as a source of income. Regardless of how a stock’s price fluctuates from there, investors in dividend stocks start out with the cushion of a positive return resulting from dividend payments, provided a stock is held when quarterly dividend distributions are made. Furthermore, a growing dividend usually reflects growing free cash flow from the underlying business. Companies that pay and grow dividends tend to be mature and well established, with the ability to better withstand economic downturns and steadily grow their business across business cycles.

If a company is growing sufficiently to generate dividends but isn't experiencing growth in cash flow, it’s liquidating. We do mean cash, and not earnings—cash is what matters, as companies are run on cash. Earnings, on the other hand, are shaped by the vagaries of accounting. A host of issues, from the treatment of inventory to the rate at which capital assets are depreciated, can lead to positive earnings while cash flow is negative, or negative earnings while cash flow is positive.

Another reason dividend-paying stocks are often less volatile is that they have less duration—or interest-rate sensitivity—than stocks that don’t pay dividends. We know that as rates rise, the prices of longer-duration instruments fall faster than the prices of shorter-duration instruments, assuming all else being equal. While the concept of duration is thought to be primarily applicable to fixed-income assets, equities also have this characteristic. Just like bonds, the more cash paid sooner, the lower the duration. A stock that provides a healthy dividend is essentially a shorter-duration equity than a growth stock that has a very low or no dividend payout.

Another important concept is that, in our view, investors should think more broadly about the ways companies can return cash to their owners. Cash dividends, which we’ve discussed, are the most obvious means. A long record of regular, growing dividends speaks volumes about a company’s stability and the priorities and shareholder orientation of its management. But buying back shares and paying down debt are also legitimate ways to return cash, as both provide shareholders with a larger claim on future cash flows. Collectively, dividends, share buybacks, and debt paydowns are known as shareholder yield.

In our view, shareholder yield is the proverbial bird in the hand: If the long-term return expectation for equities is in the high single digits, why not ask for the majority of that return up front? We might not know whether the market is overvalued or undervalued, or whether investor sentiment will be predominantly risk on or risk off, but we do know that if you make shareholder yield your main source of return, you're likely to get paid.

1 Ned Davis Research, January 2017.