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Dividends for All Seasons

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Dividend investing, with all due respect, has become such a “me too” thing. Everybody’s seemingly doing it.

Investors and financial advisors alike have rediscovered the magic of dividends as a crucial element toward successful long-term investing. And the love affair with U.S. dividend paying stocks that’s been nurtured over the past several years has been fueled to a large degree by an environment of extremes.

The post 2008–09 financial crisis ushered in a scared — not brave — new world of rock bottom interest rates courtesy of freaked out central banks like the Federal Reserve. The resulting aftermath has led to a hyper-low yield situation, which in turn has caused traditional income investing sources like corporate and government bonds to lose their appeal.

Although dividend paying stocks may be popular right now, how will they hold up if market conditions change for the worse? In this article, we’ll examine three different market scenarios — each with its own challenges — and why dividend investing can still be a powerful ally.

When Rates Rise

During periods of rising interest rates, stocks have historically appreciated in value. However, not all stocks or sectors have particpated in the gains.

A snapshot of five selected periods of rising interest rates since Oct. 1993 shows that utilities and the telecommunication services sectors consistently posted negative performance, according to a study conducted by The Boston Company Asset Management. The lone exceptions were outlier years like 2003 for utilities and 1998 for telecom, when both sectors rose in value.

If rate sensitive industry sectors like utilities underperform during a market cycle of higher interest rates in the future, dividend funds like the iShares Select Dividend ETF (DVY) with substantial exposure to utilities could take a hit.

One path toward balancing the need for dividend income with controlling sector specific risk is a novel approach taken by the ALPS Sector Dividend Dogs ETF (SDOG).

Instead of loading up on high yielding sectors, SDOG evenly divides its dividend exposure across all 10 sectors of the S&P 500 by selecting the five highest yielding securities in each sector. Each stock gets 2% representation while each sector’s market exposure is capped at 10%.

“By expanding ‘Dogs of the Dow’ theory to each sector of the S&P 500, SDOG retains the high dividend yield and deep value characteristics of the Dow strategy, but with much better sector diversification across a broader universe of stocks,” said Jeremy Held, director of research at ALPS Advisors.

SDOG’s 50-stock portfolio is rebalanced quarterly and holdings are reconstituted at the end of each year. The fund’s 30-day SEC yield is 4.07 % and the fund charges annual expenses of 0.40%.

Ultimately, advisors should be cautious about dividend paying funds or ETFs with significant exposure to rate sensitive sectors when the risk of higher rates is imminent. Mitigating these risks with a more even sector approach to dividend investing is the prudent course.

During Recessions

During a period of high unemployment, rising commodities prices and sluggish economic activity, the role of dividends takes on greater meaning. Since growth from equity returns are frequently scant, dividends can serve a dual purpose of cushioning downturns and making for the lost ground.

Over the past 40 years, dividends have held up quite well during every one of five recessionary periods that occurred, according to data from Robert J. Shiller, author of “Irrational Exuberance” (Princeton University Press). For example, while S&P 500 earnings per share dropped by whopping 42% on average during a recession, dividends per share fell by just 8% on average. Put another way, dividends were much less volatile compared to earnings during recent recessions and were cut by less than a fifth of the percentage decline in earnings.

Part of reducing dividend volatility is being invested in stocks and industry sectors with dividend levels that can be sustained even during tough recessions. For example, the SPDR S&P Dividend ETF (SDY) has over 20% of its sector exposure to defensive areas like consumer staples and healthcare. The companies in these sectors include stalwarts like Colgate-Palmolive, General Mills and Pfizer, which produce personal healthcare items, food products, and medication that people need and use regardless of the economy’s health. The dividend rates set by these companies are a reflection of their long-term earnings power.

How big of a driver are dividends upon investor returns?

A final look at low growth periods, such as the 1940s and 1970s shows that dividends accounted for over 75% of total returns! The bottom line is that dividends are an investor’s friend during low-growth recessionary periods.

Amid Inflation

The impact of inflation can be devasting. Why? Because more dollars buy less goods and services putting the pinch on the economic well-being of everyone, especially fixed income retirees.

Investing in dividend paying stocks is no less an effective way to combat the constant threat of inflation. The average growth in the S&P 500′s dividends per share (over a rolling 10-year basis) since the 1940s has been 6%. By comparison, inflation, as measured by the consumer price index (CPI) and calculated by the U.S. Bureau of Labor Statistics, grew at 4%.

The message here is that dividends over the long run can provide a meaningful hedge against the tyranny of inflation. Along these lines, advisors shouldn’t overlook the significance of companies that don’t just pay dividends but increase them.

A 42-year study from 1972 to 2014 by Ned Davis Research showed that companies that increase dividends performed the best. Stocks of dividend growers rose 10% compared to a 9.3% gain for a peer group of all dividend paying stocks and just a 2.5% gain for non-dividend payers.

The Vanguard Dividend Appreciation ETF (VIG) owns stocks that have increased dividends for 10 consecutive years or more. VIG is linked to the NASDAQ U.S. Dividend Achievers Select Index and is rebalanced annually to assure that no single stock accounts for more 4% of the index.

Summary

Many investors have increased their exposure to dividend paying securities because of a singular and compulsive focus on yield alone. Unfortunately, this has introduced a realm of unintended risks, which advisors should be identifying and explaining.

After advisors have discussed the danger of yield chasing, then what? Thereafter the conversation can shift to helping clients to use a dividend strategy that’s multi-dimensional and “all season” meaning it can work during any type of market climate.