Maybe Time To Include Dividend Growth Equities To One's Portfolio

The broadening in performance across multiple equity asset classes is providing investors with investment opportunities outside of the S&P 500 Index. The S&P 500 Index has certainly been a stalwart in terms of performance over the last five and ten years. Given the strength in the equity market and the index trading at valuation levels that some call stretched, investors might consider dividend paying stocks for a portion of their portfolio. One characteristic of dividend payers is they generally hold up better in down equity markets.

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S&P 500 Dividend Aristocrats Lag In This Down Market

A favorable characteristic of the S&P 500 Dividend Aristocrats is this basket of stocks generally holds up better in broader market pullbacks as seen in the below table. Where the entire row is highlighted, it represents a significant market pullback and the Aristocrats outperformed the S&P 500 Index by double digits. The S&P 500 Aristocrats are companies in the S&P 500 Index that have increased their dividend each year for at least 25 consecutive years. The companies are then equally weighted in the Dividend Aristocrats Index. I have written about the Aristocrats several times in the past with a more comprehensive article at this link.

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New Dividend Aristocrats For 2020

Last week S&P Dow Jones Indices announced the annual rebalancing of the Dividend Aristocrats. In the rebalancing results, no companies are being removed, but S&P announced seven new additions to the Aristocrats for 2020. This brings the number of Aristocrats to 64 companies. The changes go into effect prior to the market open on February 3, 2020. As noted by S&P, "S&P 500^® Dividend Aristocrats^® measure the performance of S&P 500^® companies that have increased dividends every year for the last 25 consecutive years. The Index treats each constituent as a distinct investment opportunity without regard to its size by equally weighting each company."

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Dividend Income Strategies Lagging In Strong Up Market

Investors positioned for higher stock and bond prices during the year have not been disappointed. With the Federal Reserve pursuing a lower interest rate policy, bond yields declined for most of the year with a commensurate increase in bond prices. Stock prices have mostly trended higher as well with some of the price increase a recovery from last year's fourth quarter selloff. Returns across most asset classes have been favorable as seen in the below chart. The top half of the chart below displays the asset classes with leading returns and is comprised of U.S. market segments with the bottom half largely foreign markets except for the income focused investments like the 10-Year U.S. Treasury.

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Dividend Payers A Winning Strategy In A Volatile Equity Market

Now that the S&P 500 Index seems to be making a habit of reaching new highs on a more frequent basis, the journey has been anything but a smooth one. One area of the market that provided for a less bumpy ride was in the dividend paying stocks. Simply evaluating the return in a few of the dividend paying strategies since the market's peak in late September of last year, a couple of the dividend paying strategies still are outperforming the total return of the S&P 500 Index as seen in the below chart.

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Dividend Payers Return Lags The Return Of The Non Dividend Payers

S&P Dow Jones Indices recently reported the return for the dividend payers and non-dividend payers in the S&P 500 Index for the period ending June 28, 2019. Given the underperformance of the value style over the past several years then it is not surprising the dividend payers are underperforming the non-payers on an average return basis year to date and over the trailing twelve months. The dividend paying stocks tend to be more defensive and have a value tilt. 

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Stock Buyback Boom In 2018

Yesterday S&P Dow Jones Indices reported stock buyback activity for the S&P 500 Index as of the end of the fourth quarter 2018. Highlights from S&P DJI report:

• Q4 share repurchases increased 62.8% year-over-year to a record $223.0 billion

• Total 2018 buybacks set record $806.4 billion, up 55.3% year-over-year, and up 36.9% from the record $589.1 billion set in 2007

• Almost every S&P 500 constituent – 444 – repurchased shares in 2018, up from 424 in 2017

• Apple spent the most in 2018 buybacks at $74.2 billion

The level of buybacks provided a tailwind for earnings growth in the fourth quarter as well as the entire calendar year 2018. S&P DJI notes, "the percentage of companies that substantially reduced share counts of at least 4% year-over-year rose to 18.8% (90 total issues), up from the prior quarter’s 17.7% (88 total issues) and Q4 2017’s 15.1% (70 total issues.)" The four quarter buyback plus dividend yield equaled 6.0% in Q4 2018 and up from 4.75% in Q3 2018.

Lastly, S&P DJI listed the below five companies as having the largest total buybacks in the fourth quarter,

• Apple (AAPL) led in buybacks, spending $10.1 billion in Q4 2018, down from $19.4 billion spent for Q3 2018. Its Q4 2018 expenditure ranked 19th highest historically; for the year, Apple spent $74.2 billion on buybacks, up from 2017’s $34.4 billion; over the five-year period the company spent $229.0 billion, and $260.4 billion over the 10-year period.

• Oracle (ORCL): $10.0 billion for Q4 2018, down from $10.3 billion for Q3 2018; 2018 was $29.3 billion, up $4.0 billion in 2017.

• Wells Fargo (WFC): $7.3 billion for Q4 2018, slightly down from the $7.4 billion spent in Q3 2018; 2018 was $21.0 billion, up from $10.3 billion in 2017.

• Microsoft (MSFT): $6.4 billion for Q4 2018, up from $3.7 billion for Q3 2018; 2018 was $16.3 billion, up from $8.4 billion in 2017.

• Merck (MRK): $5.9 billion for Q4 2018, up from $1.0 billion for Q3 2018; 2018 was $9.1 billion, up from $4.0 billion in 2017.

Stock Buybacks Up 57.8% In Third Quarter

S&P Dow Jones Indices recently reported preliminary dividend and buyback information for the third quarter ending 9/30/2018. On a year over year basis stock buybacks for S&P 500 companies are collectively up 57.8% for Q3 2018. For the 12-months ending 9/30/2018 total buybacks increased 39.1%. Relative to buybacks, dividends increased a much smaller 9.7% resulting in combined dividends plus buybacks increasing by 36.2% for the third quarter. Year over year operating earnings were reported up 25.8%.

The three largest buybacks were initiated by companies in the information technology sector:

• Qualcomm (QCOM): $21.2 billion
• Apple (AAPL): $19.4 billion
• Oracle (ORCL): $10.3 billion

For the quarter the top 20 companies initiating buybacks in the quarter accounted for more than half, or 54.3%, of the total buybacks of all S&P 500 firms.

In conclusion, I would prefer to see larger dividend increases which would be more of an indication that companies expect to see improved cash flow/earnings over an extended time frame. The recent tax cut is not permanent though; thus firms are likely hesitant to commit to higher dividend payments on an ongoing basis. The most significant tax cut expiration impacting businesses might be the phase out of the full expensing of equipment purchases beginning at the end of 2022. At the moment though, companies seem committed to returning to shareholders some of the cash flow benefits resulting from the tax cut.

Equal Weighted Equity Performance Lagged In 2017

One equity market phenomenon that played out in 2017 was the fact larger capitalization stocks were larger contributors to market returns. One way to evaluate this is to review the return of the cap weighted S&P 500 Index versus the equal weighted Guggenheim S&P 500 Index (RSP). As the below chart shows, the equal weighted index underperformed the cap weighted S&P 500 Index by more than 300 basis points. Additionally, the largest 50 stocks by capitalization (XLG) outperformed both the the S&P 500 Index and the equal weighted S&P 500 Index.

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Growth Outperforming Value And The Economic Cycle

One style of the market that has outperformed, except in 2016, has been growth type equities. In 2016 value outperformed growth with a value outperformance burst subsequent to the election. Value's outperformance essentially ended at the beginning of this year though.

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Dividend Payers Are Underperforming

A year ago dividend paying stocks were significantly outperforming the non payers in the S&P 500 Index and the S&P 500 Index itself. If investors were chasing performance back then and loading up on the payers, today they would be disappointed. Below is a chart of the year to date performance of two dividend paying exchange traded funds, SPDR Dividend ETF (SDY) and iShares Select Dividend ETF (DVY). The return of the dividend focused ETFs is nearly half that of the S&P 500 Index.  The return difference is similar for one year. My year ago post contains some details on both ETFs.

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Income Focused Investments Continue To Show Weakness

Janet Yellen's Jackson Hole comments on Friday did not do any favors for the performance of income focused investments. The Fed chairman's comments($) led market participants to believe a rate hike for September is back on the table and at least more likely in December. The rate hike fear continues to put downward pressure on income focused investments which some investors view as bond substitutes. So far in the month of August the SPDR Dividend ETF (SDY), the iShares US Real Estate ETF (IYR) and the SPDR Utilities Sector ETF (XLU) are all underperforming the broader S&P 500 Index. Also, for the month of August these three ETFs are showing negative total returns with XLU down 2% on Friday alone.

The site, ETF.com, reported the utility sector ETF was among the top 10 ETFs experiencing outflows for the week, withdrawals totaling $263 million.

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Income Oriented Equities Lag In July

In a few recent posts I have discussed the elevated valuation of dividend growth equities. It would appear bond investors have gravitated to the anticipated safety of equities that generate dividend income greater than can be found in the low rate bond market. The extended valuation of these income equities/sectors may result in investors being surprised in the event the market does encounter a pullback. In fact, August and September tend to be the the poorer performing months for stocks.

Just as the "sell in May' mantra has yet to play out this year, maybe the much anticipated August/September weakness becomes more discussion than reality. And given all the concern about this late summer weakness, in July, investors seemed to rotate out of the so-called safe income stocks and into the higher beta, more cyclical equities. As the below chart shows, the income oriented equity market segments underperformed the broader S&P 500 Index and the PowerShares S&P 500 High Beta ETF (SPHB).

From a sector perspective, the more defensive sectors in the S&P 500 Index lagged the more cyclically oriented ones as well. Energy has its own issues and the other bottom three performing sectors in July were Consume Staples, Utilities and Telecommunications. On a year to date basis the performance of these three sectors remains strong; however, Technology, Materials, Health Care and Industrials generated strong returns in the month of July. An important factor for continued strong performance in the cyclically oriented sectors is improved earnings.

 

In Thomson Reuters This Week in Earnings report, they note,

"312 companies in the S&P 500 Index have reported earnings for Q2 2016. Of these companies, 72% reported earnings above analyst expectations, 12% reported earnings in line with analyst expectations and 16% reported earnings below analyst expectations. In a typical quarter (since 1994), 63% of companies beat estimates, 16% match and 21% miss estimates. Over the past four quarters, 70% of companies beat the estimates, 9% matched and 21% missed estimates. In aggregate, companies are reporting earnings that are 4% above estimates, which is above the 3% long term (since 1994) average surprise factor, and in line with the 4% surprise factor recorded over the past four quarters."

Absent the energy sector, overall earnings appear to be on an improving trend. With respect to the energy sector, year over year comparisons will become easier starting with the third quarter.

Given the tight range the S&P 500 Index has traded in over the last two weeks, a break to the upside or downside will certainly occur. Historically, these tight trading ranges tend to resolve themselves to the upside. Having noted this, a little consolidation of the market gains since February would be healthy and not a surprise given the upcoming weak seasonal market months. And finally, investors chasing yield in stocks need to be cognizant of the rich valuations of these stocks and recent rotation may indicate some investors are figuring this out.

Dividend Payers And Dividend Focused ETFs Post Strong Returns YTD

A few prior posts have provided detail and potential consequences facing dividend focused equities given their extended valuations. Of course, in a low (and going lower?) interest rate world it seems the simple approach an investor can pursue is just buying a stock that has a higher yield than the 10-year U.S. Treasury. S&P Dow Jones Indices recently reported on the average performance of the dividend and non dividend paying stocks in the S&P 500 Index. Maybe no surprise, but the payers are swamping the non payers this year and over the last twelve months as of June 30, 2016. As the below table details, the payers have outperformed the non payers by 728 basis points year to date and by 1,142 basis points over the prior twelve months.

Also, the strong performance of the dividend payers is evident in several of the dividend focused ETFs. Below is a chart of the SPDR S&P Dividend ETF (SDY) and the iShares Select Dividend ETF (DVY) plotted with the S&P 500 Index.

• SDY seeks to replicate the performance of the S&P High Yield Dividend Aristocrats. SDY's projected income yield is 2.3%. Notable sector weights in SDY are Utilities (31%) and Financials 14%.

• DVY's performance is focused on replicating the Dow Jones Select Dividend Index and has a projected yield of 3.0%. Notable sector weights for DVY are Financials at 24% and Utilities at 15%.

Both of these ETFs are up by mid teen percentages this year through Friday's close as can be seen in the below chart.

Dividend Payers Trouncing Non-Payers Through April

If one facet of the market that has become clear this year is that companies paying a dividend are being rewarded. The below table shows data reported by S&P Dow Jones Indices on the average performance of dividend payers in the S&P 500 Index versus their non-paying counterparts. Year to date through April the payers average return return equals 6.51% versus the non-payers return of .89%. The spread is even wider for the 12-month period with the payers returning 1.66% and the non-payers return equaling -7.29%.

Data source: S&P Dow Jones Indices

We have noted the propensity by investors to favor the payers over the non-payers of late. Yesterday's post on the Dogs of the Dow 2016 performance is a version of this theme. Not that all value stocks need to be dividend payers, but the iShare S&P 500 Value ETF (IVE) has a dividend yield of 2.35% versus the iShares S&P 500 Growth ETF (IVW) yield of 1.52%. As can be seen in the below chart, value is leading growth so far this year as well.

In this low rate world it seems dividend paying stocks are gaining some respect by investors. In a slow growth economic environment though, companies that can grow earnings in spite of the economy's anemic growth rate (growth stocks) have historically performed well. Since the end of the financial crisis both growth and value tracked pretty closely up until the end of 2013. For the last two plus years though, growth has led value in performance. Maybe the tide is beginning to turn in favor of value though.

Dividend Paying Stocks Held Up Better In The Market Downturn

An attractive aspect of owning dividend paying stocks, specifically, dividend growth equities, is the fact they tend to hold up better in down market environments. The favorable result from this characteristic is it takes a smaller upside return to make up the losses incurred in a market decline.

As far back as 2010 I wrote about this favorable feature in a post, Comprehensive Review Of The Dividend Aristocrats. As noted in that article, in shorter time frames, the dividend aristocrats did exhibit a higher standard deviation, yet the total return of the aristocrats was higher than the broader S&P 500 Index and resulted in the aristocrats having a higher Sharpe ratio. A part of this is attributable to the favorable compounding impact of reinvested dividends.

As we fast forward to today and the recent downturn in the equity markets from early last year, the favorable performance of dividend paying stocks is once again evident. For the year to date period both the iShares Select Dividend ETF (DVY) and the SPDR S&P Dividend ETF (SDY) are outperforming the S&P 500 Index as seen in the below chart. During the market pullback from 12/31/2015 through February 11, 2016, the dividend focused ETFs held up significantly better than the S&P 500 Index itself. As the market has recovered, the dividend paying indexes are maintaining their outperformance and have recovered the losses incurred in the pullback.

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Dividend Paying Stocks Struggling Mightily

In a post last month we highlighted the fact value strategies and dividend paying strategies were lagging both the S&P 500 Index and the S&P 500 Growth Index over the past twelve months. Frequently the value type stocks have a dividend component that provides additional return for investors.

Further confirmation that dividend paying strategies have been underperformers can be seen below. S&P Dow Jones Indices reports the average performance of the dividend payers in the S&P 500 Index have lagged the non payers by a wide margin, both year to date and over the course of the past twelve months as of April 30, 2015. For the one year period the payers return of 12.85% falls far short of the non-payers return of 20.64%.

From The Blog of HORAN Capital Advisors

Source: S&P Dow Jones Indices

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Higher Yield and Value Oriented Strategies Underperforming Broader Market

One interesting aspect of the recent equity market advance has been the investor focus on higher quality dividend growth equities. A result of investors' search for yield is many of these higher yielding equities are trading at the higher end of their historical valuation range. Also, given the heightened focus on yield, one would expect the higher quality dividend growth equities to have outperformed the market over the past year. However, as the below chart shows, the SPDR Dividend ETF (SDY) has generated the worst 1 year return versus the other three comparison investments. The second worst performer is the S&P 500 Barra Value Index.

From The Blog of HORAN Capital Advisors

Although investors have pursued higher yielding investments in this low yield environment, the higher demand has not resulted in higher returns. The underperformance of higher quality and higher yielding investments may be a shorter term phenomenon, but investors simply need to be aware that pursuing higher yield/higher quality strategies can result in lagging performance if only in the short run. On the other hand, in a market correction higher quality and higher yield equities tend to outperform the overall market.

A Good Quarter To Be a Non-Dividend Paying Stock

Through the first quarter of 2015, performance would suggust it was a good time to be a non dividend payer stock. As the below table shows, the average return of the non-payers generated a return of 6.49% versus the payers average return of 1.16%. I would note, however, the average return in the quarter for both the payers and non-payers exceeded the cap weighted return of the overall S&P 500 Index.

From The Blog of HORAN Capital Advisors

Dividend Payers Underperformed Non Payers In 2014 And Equal Weighted Risk

The chase for yield in 2014 did not lead to the dividend payers in the S&P 500 Index to outperform the non-payers. As the below table shows, the average return of the payers, 14.99%, fell just short of the average return of the non-payers that generated a return of 15.44%. The average return for both categories though did beat the cap weighted return of the overall S&P 500 Index.

From The Blog of HORAN Capital Advisors

Source: S&P Dow Jones Indices

Jim Paulsen, Ph.D., Chief Investment Strategist at Wells Capital Management, recently wrote a research article on valuation of the S&P 500 Index. In his report, Median NYSE Price/Earnings Multiple at Post-War RECORD, Paulsen notes the median stock in the index trades at a record high valuation at approximately 20 times earnings. The report notes historically, when the market traded at high valuations, investors could find certain sectors not trading at high valuations. An example noted in the report,

"The 2000 stock market was characterized by a significant overvaluation among the fifth to 20th P/E percentiles while valuations in most of the rest of the market were either average or below average. Today, the entire stock market (low P/E stocks to high P/E stocks) appears highly valued relative to history. Similarly, Chart 8 [in the report] illustrates that today’s valuation profile is also much more broadly extended than it was at the top of the 1970’s Nifty Fifty era."

According to Paulsen, an implication of this high median valuation could be cap weighted indexing for the U.S. market will generate better returns than an equal weighted approach. Additionally, international market valuations suggest opportunities may exist in those markets vis-à-vis the U.S. Several of his comments in the report around this topic,

• "First, the valuations of U.S. stocks are much higher than widely perceived or as suggested by the valuation of the popular S&P 500 Index. Moreover, today’s valuation extreme is not limited only to a subset of stock market sectors but rather is very widespread whereby nearly all P/E multiple percentiles are at or close to post-war records."

• "Finally, the current valuation extreme is not the result of poor performance from a single valuation metric. U.S. stocks are broadly and richly priced compared to earnings, cash flows, and book values. Second, because valuation dispersion is relatively low today, there are not many areas to hide from overvaluation. In 1973 or 2000, investors could reduce extraordinary valuation risk by simply diversifying away from the Nifty Fifty or new era tech stocks. Today, because values are both high and tight, lessening valuation risk may not be possible except by allocating away from U.S. stocks."

• "Today, even though a larger portion of the overall stock market is aggressively priced, it has not garnered nearly as much attention. A concentrated valuation extreme tends to loudly announce itself whereas a broad-based valuation extreme seems more stealth and, therefore, perhaps more dangerous."