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.
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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.