Asset Allocation: Caution Toward High Dividend Yielding Stocks

Why Have High Dividend Yielding Sectors Done Well This Year?

Reach for yield. In response to weak nominal growth, central banks have maintained accommodative monetary policies, pushing interest rates to historic lows. Given this low-yield environment, investors have flocked to stocks that yield more than traditional U.S. Treasuries.

Perceived Stability. Generally, companies with higher dividend yields tend to be slower-growing and more stable, with enough excess cash to pay out dividends. Investors view these stocks as relatively safe defensive havens that offer a bulwark against declining or volatile markets.

Positive fund flows. Dividend-oriented stocks and funds have experienced large capital inflows this year. According to Morningstar, overall assets in dividend-focused ETFs and mutual funds have ballooned to $672.6 billion, nearly double the $367.3 billion in assets they held in 2011.

While the factors above have buoyed dividend-rich stocks this year, such stocks now pose a rising risk in portfolios for several reasons:

1. Their valuations have stretched beyond what is justified by the fundamentals in many cases.
2. Companies with unsustainable dividend growth run the risk of cutting dividends and suffering significant underperformance as a result.
3. A negative change in sentiment could lead to major outflows from focused mutual funds and ETFs.
4. Dividend stocks and funds are typically highly sensitive to interest-rate movements.

Cause for Caution: Why Dividend-Rich Stocks Pose A Greater Risk

Stretched Valuations. Defensive, high-yielding sectors are trading at a premium to the U.S. stock market (chart 1). Companies in these sectors tend to grow slowly and require meaningful capital investment, which typically leads to higher leverage (chart 3). Higher yields theoretically compensate investors for these growth and leverage drawbacks. However, these stocks may sell off if interest rates rise, or if they are forced to cut dividends due to unsustainable payout ratios, weak earnings growth or both.

In comparison, sectors such as technology, health care and consumer discretionary generally offer better growth and more attractive valuations (table 1).

Passive Inflows. Dividend stocks have been lifted by investor demand for lower volatility ETFs and index ETFs. Remember that when investors buy a passive, market-cap-weighted ETF, they inherently buy expensive parts of the market that have been performing well, and heavy purchasing of such ETFs can push elevated valuations even higher.

Interest-rate sensitivity. Dividend stocks are typically also highly sensitive to interest rate and bond yield movements. In 2013, as the Fed ended its bond-purchasing program, U.S. Treasury yields surged and utilities, telecommunications and consumer staples stocks as well as REITs lagged the S&P 500 Index (chart 2).

Investors with exposure to these stocks should carefully consider the interest-rate sensitivity within their equity allocations. As central bank actions lead to market volatility, dividend-rich stocks are likely to be disproportionately impacted.

For example, throughout September of this year, volatility spiked as investors focused on potential Fed rate hikes, and dividend stocks fell more than the broader market. From August 31st to September 21st, the S&P 500® Dividend Aristocrats® Index (an index of 50 stocks with 25 consecutive years of dividend growth) returned -1.78%, versus -0.26% for the S&P 500 Index.

Conclusion. High dividend-yielding stocks have been the primary drivers of recent stock-market performance. However, we have avoided these stocks because of their overly-rich valuations as well as their sensitivity to interest-rate movements, central bank policies and reversals of trends in ETF and mutual fund flows. We were wary of these sectors at the beginning of the year and are even more so now. We continue to favor companies within sectors that are structurally more attractive and are reasonably valued compared to the rest of the equity market.

The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.

Bloomberg Barclays Aggregate Bond Index is an unmanaged, market-value weighted index comprised of taxable U.S. investment grade, fixed rate bond market securities, including government, government agency, corporate, asset-backed, and mortgage-backed securities between one and ten years. Bloomberg Barclays Indices are trademarks of Bloomberg or its licensors, including Barclays Bank PLC.

S&P 500® Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Criteria evaluated include: market capitalization, financial viability, liquidity, public float, sector representation, and corporate structure. An index constituent must also be considered a U.S. company. S&P 500® Dividend Aristocrats® Index tracks performance of companies in the S&P 500 who have increased their dividends for at least 25 years. The list typically contains 40-50 companies and is updated annually in January. Companies are removed if they fail to increase their dividends from the previous year. Dividend aristocrats must have a float-adjusted market capitalization of at least $3 billion and an average trading volume of at least $5 million. Standard & Poor’s, S&P, and S&P 500 are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”), a subsidiary of S&P Global Inc.

One cannot invest directly in an index.

S&P 500® sector characteristics using GICS Level 1 Sectors, as of 09/30/2016.

Price-Earnings Ratio (P/E Ratio) is the ratio of the share of a company’s stock compared to its per-share earnings. P/E calculations presented use FY2 earnings estimates; FY1 estimates refer to the next unreported fiscal year, and FY2 estimates refer to the fiscal year following FY1.

Dividend yield for the underlying stocks is calculated by dividing the total dollar amount the security paid out as income to shareholders by the share price.

Annualized total return is the geometric average amount of money earned by an investment each year over a given time period.

Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock.

The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and Standard & Poor’s. “Global Industry Classification Standard (GICS), “GICS” and “GICS Direct” are service marks of Standard & Poor’s and MSCI . “GICS” is a trademark of MSCI and Standard & Poor’s.

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