Long ReadAug 4 2022

Dividend income investment can play a bigger role in your portfolio

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Dividend income investment can play a bigger role in your portfolio
(FT Money)

Rising interest rates and worries about the pace of economic growth around the world have raised concerns over the elevated valuations of many previously high-flying growth companies.

As such, dividend-paying equities are emerging centre stage.  

With bond yields rising and inflation soaring it is clear that dividend income investment could play a more significant role in the total return of a portfolio. Against this backdrop, we explore four emerging trends in the dividend universe.

Positive correlation between dividend yields and bond yields

For most of the past 30 years, the relative returns of high dividend-yielding stocks and changes in US Treasury yields had a negative relationship.

That relationship reversed in the past two years and high-yielding stocks have exhibited a positive correlation to bond yields. If this trend continues, a rise in interest rates may not dampen prospects of dividend stocks as they have in the past.

Partly this is because interest rates are rising, but from a fairly low base. Against this backdrop, dividend-paying stocks provide a combination of income while providing the potential for capital appreciation, especially since the valuations of many of these companies appear reasonable following a long bull market for growth stocks.

That said, it is important to identify companies with heavy debt loads or excessive leverage on their balance sheets in a rising rate environment. 

 

Dividends are making a comeback, but at a measured pace

We expect a steady increase in global dividends, but at a steady pace. Companies with pricing power and sustained cash earnings are likely to be better positioned to increase dividends.

For example, household products giant Procter & Gamble has already raised prices across some of its product lines to help hedge itself against inflation. Consumer staples makers are often hurt when inflation begins to move higher and input costs go up.

However, after a period of three to six months, these companies often seek to reprice contracts with retailers and grocers. This puts them in a better position to recoup those raw material costs, grow their earnings and potentially increase their dividend at a commensurate rate.

One industry emerging with tremendous growth potential is semiconductors, driven by its pricing power ability and high, resilient operating margins.

Demand for semiconductors is increasing because we need them more than ever as digitisation continues at an unprecedented pace. The margins are also extremely high as the industry is now very specialised and there are only a limited number of semiconductor companies currently.

Even when the cost of raw materials is rising, the margins are still large enough that these price increases can be passed on to the consumer.

Highly cyclical firms take an innovative approach with variable dividends

Some companies, especially those in cyclical industries, are adopting innovative approaches to balance their business needs and a commitment to paying dividends.

Take the mining sector, which in 2021 witnessed a boom in dividend payouts. Over the past few years, many large mining companies, such as Rio Tinto and Vale, have switched from progressive dividend policies to a payout ratio.

In these arrangements, dividend payouts are determined by a formula tied to certain operating metrics. This shift results in a variable dividend yield over time, but it also gives these companies an enhanced ability to manage their balance sheet and cash flows in a sustainable manner through multiple commodities cycles.

Financials, energy and healthcare are areas of dividend opportunity

Financials, energy and healthcare represent a substantial chunk of the dividend-paying universe, and a confluence of factors appear to support the case of rising dividends from each of these areas.

Financials: Rising rates should help the more rate-sensitive banks in the US and Europe expand their net interest margins, which have been suppressed for many years by persistently low interest rates. This could result in stronger earnings, improved dividend streams and higher valuation multiples.

Energy: Large integrated oil companies have long been reliable sources of consistent dividends for income-oriented investors. They have also become more disciplined on supply, having curtailed investment in existing reserves and pursuing new sources of oil. Furthermore, there is no doubt the quality of earnings is improving as revenues begin to diversify into growing areas such as renewable energy. 

Healthcare: Healthcare companies could be a source of both earnings and dividend growth in the current inflationary environment. Pharmaceutical companies historically have exhibited strong pricing power. While the industry has faced political pressures on drug prices, the more innovative pharmaceutical companies will be positioned to raise prices at modest levels.

As market volatility increases, dividend income investment could play a more important role in the total return of a portfolio. Investors are likely to pay greater attention to dividend payers – and those able to sustain dividend growth – as companies reinstate or continue to raise their dividends, albeit at a gradual pace.

Furthermore, long-term investors have an opportunity to get in at the ground level amid this changing landscape where many companies are currently trading at attractive valuations that may not be fully reflecting their upside potential.

Julie Dickson is investment director at Capital Group