Long Read  

Dividend income investment can play a bigger role in your portfolio

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.