Dividend-paying stocks hold mass appeal, but caveats apply.
Everybody loves a juicy dividend, and why not? Consider that the risk-free rate on 10-Year Treasuries shockingly dipped below 1.4% in Q3 of 2016. Not many pundits predicted that. Even as 10-year Treasury rates have risen over the last several years, rates remain low by historic standards, and not many investors can rely on such paltry fixed income yields to meet all of their investment objectives.
Is it any surprise, then, that investors are looking high and low for income alternatives? We believe that select equity income strategies can play a valuable role in a broadly diversified portfolio, not only for their yield potential, but also for their total return and risk-mitigating benefits. Nevertheless, investors should understand that naively selecting equities with the highest yields is not always a winning strategy. Rather, building a portfolio of dividend stocks needs to be carried out with precision, research insights, and a meticulous focus on underlying company fundamentals.
Do Dividends Matter?
Yes, dividends really do make a difference. For evidence, consider that yield has been a significant contributor to total large company stock returns over the past several decades. Since January of 1996, the S&P 500® Index has returned an average of 8.3%, but 41% of this total return is represented by dividends and capital appreciation on reinvested dividends.
“No question about it, dividends have been — and will likely continue to be — an important driver of total returns,” states William Cazalet, head of Multi-Factor Equity Strategies with BNY Mellon Asset Management North America Corporation and portfolio manager of Dreyfus Equity Income Fund (Class A DQIAX). “We’re very engaged in building a strategy focused on companies that have the capital discipline to pay attractive dividends. This tends to be an attractive pool of companies and a great starting point. Plus, research shows that higher-yielding strategies tend to hold up better in down markets. That’s important as the bull market continues to age and in an environment where geopolitical risks appear elevated.”
But in pursuing an equity income strategy, perhaps the most important takeaway for investors is that selecting the highest-yielding companies is not a particularly savvy way to build a portfolio. For proof, look no further than the past twenty plus years. If an investor bought only 20% of companies in the S&P 500® with the highest dividend yields, that investor would have underperformed the index.
Cazalet reminds us that the dividend yield rises as company share price declines, all else being equal. Thus, if a company has poor fundamentals and its share price gets punished, the yield will still appear lofty. However, the logical next step for any company with deteriorating fundamentals might be to cut the dividend. So in practice, it would not be uncommon to see yields rise just before being reduced or even eliminated completely. That’s why we believe chasing yields alone amounts to a value trap, and building a portfolio exclusively predicated on dividend yield is much riskier than it might appear.
In addition to underperformance, chasing yield can also manifest itself in a portfolio with unwanted sector concentrations and unintended risk. A few years ago, a portfolio heavy on energy master limited partnerships (MLPs) would have captured many of the top-yielding domestic companies. But plummeting oil prices raised questions about the health of energy MLPs’ balance sheets and their ability to service their debt. Fears of widespread bankruptcies hampered the entire sector, which was severely punished in 2015, over 30%.* More recently, in 2017, the growth-rich, yield-poor information technology sector, produced a gain of nearly 39%. And at 23% of the S&P 500 Index, the tech sector contributed 41% of the total market gains. The top 100 dividend payers only included, on average, 10% in tech stocks, which proved to be very detrimental to overall returns. Bottom line, the pursuit of high yields exclusively might generate high income in the short term, but it can also result in sector concentration and unacceptable levels of volatility.
A Better Way
How, then, should investors build a portfolio that seeks to capture the potential benefits of higher-dividend-paying equities? “We prefer to identify companies with strong and sustainable fundamentals, along with above-average dividend yields,” explains BNY Mellon Asset Management North America Global Investment Strategist Syed Zamil. “It’s not either-or. Having one without the other just won’t work over the long term.”
This is where Dreyfus Equity Income Fund — which offers a monthly dividend payout — can leverage the BNY Mellon Asset Management North America Multi-Factor Equity Research platform to systematically identify and evaluate attractive portfolio candidates based on fundamental drivers of equity returns. The platform not only aims to help control risk at the sector level, but it also helps identify areas to seek potential outperformance based on valuation, quality of earnings and fundamental growth.
“But with so many investors seeking equity income, it’s imperative to pay close attention to valuations and to follow disciplined risk protocols,” warns Zamil. “These are hallmarks of our Multi-Factor Equity Research platform, which has helped Dreyfus Equity Income Fund build a portfolio that stacks up favorably to the broad market in terms of trailing and forward-looking valuation metrics.”
So while the S&P 500® is trading at approximately 17.0 times earnings projections for each company’s next fiscal year (as of the end of the first quarter 2018), the Dreyfus Equity Income Fund portfolio is trading at 13.5 times on the same basis. “In our strategy we explicitly pay attention to valuations, and we are quite comfortable buying quality names at current levels,” adds Zamil.
Dreyfus Equity Income Fund also aims to manage risk at the sector level. Using the S&P 500® as the benchmark, the team aims to be within roughly 3% to 5% of that sector allocation in the portfolio. This helps us avoid unwanted bias and is another example of the team’s risk-aware approach.