When interest rates are low, investors often turn to equities to generate portfolio income. That makes sense. But in today’s challenging environment, simply reaching for the highest-yielding stocks may not be the right approach.
Dividend-oriented strategies have traditionally been thought of as a more conservative way to invest in equity markets and increase income potential. Many investors find it reassuring that a portion of the potential returns generated from owning dividend stocks have some degree of reliability since they are not simply relying upon price movements, which can be volatile.
But the pandemic has reminded investors that dividend payouts are not guaranteed. So far in 2020, more than half of the top 25 yielding US companies have cut their dividends1. Some have reduced their payouts because they recognize that their businesses cannot generate sufficient earnings due to operating limitations. Others have faced competitive pressures or have struggled with too much leverage.
We still think there are opportunities to boost income in the equity market. But identifying the winners in today’s environment and avoiding the losers may require an active approach that looks beyond the level of dividend yield.
Looking Under the Hood
Based on our findings, more than 80% of US dividend Exchange-traded Funds (ETFs) underperformed the S&P 500 during the equity drawdown period, and half of them did not bounce back as strongly as the index in the subsequent recovery2. And the ETFs with the highest dividend yields had some of the worst returns, in part because of exposure to the high-yielding energy sector, which significantly underperformed.
Dividend strategies also tend to be value-oriented, favoring stocks that trade at lower multiples to earnings or book value. This also typically increases exposure to cyclical stocks that are sensitive to the economic cycle, such as energy, financials and consumer retail. About 80% of the top 25 yielding US companies that cut dividends this year were in the energy or consumer discretionary sectors.
Being Active and Focusing on Quality
An active approach that targets companies with strong balance sheets can zero in on “quality dividends.” Such dividends may not be the highest on offer, but we think they are at less risk of being cut. As the chart shows, dividend-paying stocks in the S&P 500 that are in the second quintile tend to be stronger on dividend sustainability metrics, particularly when compared to the S&P 500 stocks with the highest yields.
Source: Morningstar Direct, GSAM as of 5/20/2020. Dividend Quintile 1 stocks have an average yield of 7.3%, and dividend quintile 2 stocks have an average yield of 3.8%. The quintiles are based on S&P 500 stocks' 12-month yield. Please find additional definitions in the glossary.
So what can income-oriented investors do?
First, we think it’s important to recognize that not all “value” is created equal. Investors may consider leaning more heavily into defensive value sectors like healthcare, consumer staples, and communications and avoiding more cyclical ones.
Second, investors may focus on sustainable income by minimizing exposure to the highest-yielding stocks. This doesn’t mean giving up on income; about 80% of stocks in the US offer a higher dividend yield than the 10-year US Treasury bond. In other words, there is plenty of potential opportunity to generate additional income.
Finally, some investors may also want to consider using call-writing strategies as a way to generate additional income. This involves selling the right to another to buy an underlying stock the investor owns at a predetermined price in exchange for fees. This can be a good way to boost income particularly when an investor thinks future upside for the stock in question is limited.
We believe targeting the equity market for income is a viable strategy, particularly with interest rates at record lows. But in this difficult economic environment, we believe it’s important to embrace an active approach. High dividends may not be enough. Strong balance sheets and durable secular growth potential may just be as important, and companies that have them are more likely, in our view, to avoid dividend cuts.