Is there upside in global equities, given frothy valuations and an almost unheard-of bull market? We hear this concern a lot. These are historic times: major U.S. stock markets are up over 260% since 2009. The past 50 years have seen only two better rallies. Even so, equities today appear more attractive than bonds, and cash, not just in the U.S. but in international markets too.

Yet as quantitative investment managers, we constantly analyze performance drivers on a risk-adjusted basis. Focusing on risk often helps investors who have portfolio gains they want to protect, should U.S. market conditions change, but also want to participate in future equity opportunities, here and abroad.

I absolutely believe there is room for upside in international equities, even as forecasts for economic growth are positive, but low. No one expects dramatic increases. Investors who want to take profits from soaring U.S. stock holdings can find plenty of opportunity and diversification by investing (selectively) in income-producing stocks on international markets.

Upside potential is particularly strong in high-quality, dividend-paying stocks that can sustain and grow dividend payouts. Not all dividend-paying stocks are alike, so the key is to buy the right companies, in the right markets, without taking on additional and unnecessary risk.

Dividends Can Add Significant Value

Since 1969, the cumulative price return of the European equity market (as measured by the MSCI Europe Index) is up a healthy 1,462%. However, by reinvesting the dividends from those companies instead of taking the cash, the performance would be a powerful 8,593%!

Over the same period, U.K. equity markets (measured by the MSCI UK Index) were up 2,045% on a price return basis; when the dividends were reinvested, the performance was a startling 10,990%.

That is the power of compounding and dollar cost averaging: own companies that can sustain, and grow, dividends. If the market goes down, stockholders receive the same dividend that can be reinvested in lower-priced shares. When the market recovers (as it has, consistently), investors own more shares and participate more fully in the upside.

Since 2000, dividends have contributed 95% of the total return achieved by European equities. In the U.K., dividends were 89% of total return; in Germany, 84%. All this as GDP growth trended downward. Carving out periods of 0-2% real GDP growth back to 1970 shows that dividends still comprised over 50% of U.K. total return, 24% in Germany.

Global Growth Stuck in Slow

Examining the rolling real GDP growth of the United Kingdom and Germany for the past 47 years, a trend line pointed directly to where we are today — at roughly 2% real growth, down from a starting point of 4% in 1969. We see similar trends across Asia and the U.S. With the exceptions of Australia and South Korea, the International Monetary Fund forecasts growth of approximately 2% for Europe, the U.S. and most of Asia — for the next several years.

Productivity, a key driver of GDP as well as company earnings, is low and holding back growth. In a low-growth environment, when uncertainty about the future increases, companies often refrain from substantial capital investments in technology and other drivers of productivity growth. Add in global political uncertainty, destabilized trade policies and increasing regulation, and there is no catalyst on the horizon to change the 2% trend. If this becomes a headwind for future equity performance, the importance of dividends will become even more pronounced.

Spotting Dividend Achievers and Avoiding Deceivers

Dividend-paying stocks carry specific risks. Investors must tread carefully. High dividends may have resulted from stock sell-offs, or a company’s situation may have deteriorated due to sector- or company-specific reasons. In these cases, companies often cannot sustain high dividends and will be forced to cut them — a bearish signal always punished by markets. By following these criteria, investors can benefit from dividend investing without taking on additional risk:

Sound Financial Health: Buy stocks with high sustainable dividends they can continue to pay because they have the cash flow. Usually conservatively run, these companies can lead to strong, long-term capital appreciation. Commitments to pay high percentages of earnings in dividends often prevent companies from undertaking value-destructive activities.

Return Stability: Lower-volatility stocks with reduced exposure to economic cycles can deliver more stable returns, over time, and less downside risk.

Attractive Fundamentals: Companies that are more attractively valued than their competitors judging by balance sheets and cash flow statements, combined with a sentiment catalyst such as faster growing earnings or higher earnings estimates, provide potential for outperformance. 

Done right, dividend investing can be a low-risk way to potentially increase the certainty of outcomes in a low-growth world. Investors should pick stocks that provide sustainable, growing dividends — dividend achievers — while avoiding dividend deceivers with high dividends that look attractive, but do not have the strength to sustain payouts, and only add risk to a portfolio.