Myriad global concerns have stirred up financial markets over the past several years. Volatility may have become a new norm, bringing many changes to the investment landscape. Amid bouts of widespread uncertainty, many investors committed their assets to the bond market. Recently, however, we have seen increased interest in equities. One segment of the market that remains particularly compelling, in our view, is dividend-paying stocks.
Low, long-term interest rates continue to drive new issuance activity in credit markets, as companies extend maturities and refinance at lower debt costs. Both yields and credit spreads have contracted across the fixed income markets, driving prices higher and reducing the potential for longer-term total return.
Meanwhile, many developments have made investments in stocks, especially dividend payers, more attractive. Corporate fundamentals remain favorable, with companies reporting record earnings and generating healthy cash flows. Companies have continued to enhance shareholder value through increased share repurchases and higher dividend payouts. Though equity markets are higher, we believe valuations in the market are currently attractive according to various metrics such as price/earnings, enterprise value to EBITDA and free cash flow margin relative to historical levels.
While much has been written on this topic in the recent past, we believe many factors, such as an increasingly diverse array of companies paying dividends, high cash levels on corporate balance sheets in combination with low dividend payouts, generally healthy earnings and consistent cash flows, and a continued search for income among investors, all bode well for dividend-paying stocks.
A Broadening Opportunity Set: More Than Just Utilities
Despite the challenging environment of the past several years, the broad U.S. equity market has generally recovered from its 2009 lows. Many U.S. companies cut costs, improved their operations, and strengthened and recapitalized their balance sheets. Growing cash balances allowed many firms to implement favorable dividend actions, leading to a broad and diverse opportunity set available to dividend-oriented investors.
We continue to see dividend initiations and increases across a range of sectors. Such sectors extend beyond utilities, a space usually considered the staple of dividend investing. In fact, we are seeing initiations and increases in sectors that are historically characterized as having weaker dividend profiles, such as information technology. At the end of 2012, most sectors in the S&P 500 Index had higher dividend yields than they had 15 years ago—with dramatic increases in some cases.The chart below shows the sector yields within the S&P 500 Index illustrating improvements across most sectors since the 2008 financial crisis.
Generally, payment of regular dividends and dividend increases is an indicator of the financial health and ability of a company to weather periods of slow growth or contraction. Dividend-paying companies tend to have a strong financial footing, leading or competitive positions in their industries, and experienced management teams.
These dividend payers often command high or growing market shares, sustainable competitive advantages over their peers, strong margins and stable cash flows. These are some of the characteristics that allow companies to return capital to shareholders in the form of dividends. A solid financial position is also often reflected in investment-grade ratings by credit rating agencies.
As seen in Chart 3, high credit-quality companies tend to pay dividends.
Dividends can be an important source of income and total return for investors. This is particularly true now, as yields within fixed income markets have been hovering at historic lows. Moreover, compellingly low interest rates have allowed many companies to refinance their debt at much lower rates and include covenants that may be unfavorable for fixed income investors.
Overall, the potential for total return within the fixed income markets has decreased, in our view.
In contrast, yields on dividend-paying equity continue to be attractive relative to yields available in the fixed income markets. With dividend payout ratios at the lower end of the historical range (just over 30% for the S&P 500 Index as of April 30, 2013, compared to historical levels—March 31, 1962 to December 31, 2012—of about 50%), and cash balances at the higher end (the S&P 500 Index’s cash as percent of total debt stood at 37% as of April 30, 2013), we believe current dividend levels appear sustainable and have room to grow.
Moreover, dividend growth may help to support and lift the level of income stream that investors receive when interest rates rise, while the interest paid by bonds is generally fixed.
Another important consideration for income-seeking investors is related to differences in the taxation of dividend income relative to interest income from bonds. While uncertainty surrounding the U.S. budget deficit reduction measures, including the tax increase on dividend income, led to some volatility within dividend-paying equity markets at the end of 2012, the dividend tax increase turned out to be less burdensome than some had been feared.
Qualified dividend income is now taxed at a maximum rate of 20% (up from 15%), while interest income from bonds is taxed at the same rate as ordinary income, which may be higher than 20% for most investors. Additionally, qualified dividends became a permanent part of the tax code.
While some observers argue that the dividend trade has become overcrowded, the whole segment cannot be described this way.
We continue to identify an array of investments in the dividend-paying equities space by scrutinizing individual companies’ fundamentals, projecting their growth prospects, and aiming to recognize high-quality stocks that we believe have not been fully rewarded by market participants.
Investing in dividend paying stocks involves risks. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Companies cannot assure or guarantee a certain rate of return or dividend yield; they can increase, decrease or totally eliminate their dividends without notice.
This article reflects the analysis and opinions of the author as of June 26, 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments.
Because market and economic conditions are subject to rapid change, the analysis and opinions provided are valid only as of June 26, 2013. The commentary does not provide a complete analysis of every material fact regarding any country, market, strategy, industry or security. An assessment of a particular country, market, security, investment or strategy may change without notice and is not intended as an investment recommendation nor does it con- stitute investment advice. Statements about holdings are subject to change, apply only to the strategies managed by Alan Muschott, CFA, vice president and portfolio manager of Franklin Equity Group, Franklin Advisers, Inc., and do not necessarily apply to the holdings of portfolios managed by other portfolio managers at Franklin Templeton Investments. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy.