The last few weeks have seen some of the worst sell-offs in global equity markets since the dismal days of 2008 amid concerns over the developed world's debt woes and an increasingly tepid economic recovery. While it's perfectly understandable to feel deflated by the slew of bad news, investors should remember that the best long term buying opportunities often emerge in market downturns. Although it's impossible to know if we've hit bottom yet, it is fair to say that the recent mass selling has been quite indiscriminate and stocks in some areas of the market look cheap now. This is certainly the conclusion Warren Buffett came to in early August when in one day Berkshire Hathaway (BRK.B) spent more money buying up shares than any other day this year. "I like buying on sale", he said. Well, I imagine everybody does, although not everybody has the courage to jump in, especially when others are streaming towards the exits.
Now, very few investors are as skillful as Warren Buffett when it comes to identifying bargains. So for those who are not confident in their stock-picking skills, exchange-traded funds (ETFs) can represent a good option.
One area of the market that caught my attention before the turmoil and that looks even more appealing now from a long-term perspective is dividend-paying stocks. Dividends are one of the few "constants" (obviously some dividends are more consistent than others) in the world of investing. In fact, many studies have shown that dividend payments have historically contributed at least a third of stocks' total return. Also, because dividend paying stocks tend to be engaged in relatively steady businesses, they also tend to be less volatile than stocks that don't pay dividends. As such, they are often seen as "safe-heaven" investments during times of market volatility like those experienced recently.
Given the current environment of persistently low interest rates, the case for dividend-paying stocks looks even stronger, particularly for income-starved investors. As we write, on average, many of these stocks offer more than double the 2.5% yield on 10-year U.K. government bonds. And although they are riskier, they also provide more capital-appreciation potential in the long run, especially as one must assume that interest rates will eventually rise from their current extremely low levels, which will inevitably send bond prices lower.
Finally, dividend-paying stocks can also provide good inflation protection. Empirical studies have shown that those companies that tend to pay out rising dividends generally provide goods and services that are able to keep pace with inflation. For example, utilities can raise their rates fairly easily because they have substantial pricing power. Food and energy companies too find ways to pass on their input costs to consumers.
Dividend ETFs Vary in Their Approaches
In response to investors' interest in income strategies, European ETF providers today offer more than 20 ETFs that focus on dividend paying stocks. And while all these funds provide liquid and diversified access to stocks with strong dividends, they vary in their approaches.
Some dividend-focussed indices weight constituents by their dividend yield, not by market capitalisation, so higher-yielding stocks make up a larger percentage of the fund than lower-yielding stocks. While this approach--adopted by several funds in Europe--might appeal to investors hungry for current income, it has a flaw. The largest dividend yields tend to come from stocks that have fallen in value--some of which may be likely to cut their dividend in the future. In other words, the most generous companies today (as measured by their current dividend yield) might not be able to sustain their dividend payout in the future. In fact, when looking at the top holdings of the funds adopting this strategy, you can see that they are not necessarily the largest, best known and most stable companies within their universes. For example, the iShares FTSE UK Dividend Plus ETF (IUKD), which offers exposure to the 50 highest yielding UK stocks (the ETF is currently yielding 5.4%), has Drax Group (DRX) amongst its top holdings. The utilities group cut its dividend in 2008 and saw its share price decline so sharply in 2009 that the company lost its place in the FTSE 100.
One way to avoid the riskier dividend-payers is to focus on high-quality companies, i.e. on stocks that can sustain their current dividends or even raise them in the future. These companies usually are market leaders with strong brand names that have exhibited consistent dividend growth to date. This approach will probably appeal more to investors favouring income stability over high yields. One of the best examples we can give to illustrate that strategy is the U.S.-domiciled Vanguard Dividend Appreciation ETF (VIG). This fund uses a market-cap weighted approach and invests in firms that have raised dividends for 10 straight years. It then imposes additional tests of its constituents' financial strength in order to further ensure dividend quality. The strategy helped the fund to avoid overweighting financials before the financial crisis. While there are currently no ETFs in Europe that follow the exact same approach to hone in on consistent, high-quality dividend payers, a few (see this table) still apply a handful of filters that allow the funds to focus on the companies that are most likely to sustain their past dividend growth. For instance, the iShares EURO STOXX Select Dividend 30 ETF (IDVY), which offers exposure to the 30 highest dividend-paying eurozone stocks, includes only companies that have a positive historical five-year dividend-per-share growth rate and a dividend to earnings-per-share ratio of less than or equal to 60%.
Searching for Yield Amongst Sector Equities
Another way, albeit less obvious and probably more risky, to gain access to dividend-paying stocks is to invest in high-yielding sector ETFs. Sectors like telecommunications, utilities, energy and healthcare tend to have a high concentration of dividend-paying stocks.
For instance, telecommunications, which has traditionally been a high dividend paying sector, currently offers some of the richest dividend yields. There is a caveat though: some of these ETFs' benchmark indices are highly concentrated, with the top 10 constituents accounting for almost 90% of the index's value. Vodafone (VOD) accounts for about a third of the total value of both STOXX Europe 600 Telecom and MSCI Europe Telecom Services indices. To mitigate this concentration risk, Source offers an ETF that tracks an optimised version of the STOXX Europe 600 Telecom Index. This fund provides a relatively higher degree of single stock diversification by employing a cap mechanism which limits the weighting of each constituent to 20% of the index's value.
In times of high economic uncertainty like we are experiencing now, exposure to utilities and healthcare--two other historically defensive sectors offering generous dividend payouts--can also provide the safety that some investors are looking for as these sectors benefit from relatively stable demand across economic cycles.
The energy sector--another traditional rich source of dividend yields--might represent more of a risk at the moment because of its inherently cyclical nature. Fundamentals for oil and gas are likely to remain pressured through 2011 as recent economic indicators from the U.S. and Europe, plus a slight deceleration in China's growth in recent months, have cast a shadow on global growth prospects.
Finally, investors should be very mindful of the financial sector, another traditionally big dividend payer. A large number of banks cut their payouts in the midst of the financial crisis as capital preservation became paramount. They have taken a serious beating again over the past few weeks and the outlook for the sector remains extremely uncertain amid the lingering eurozone sovereign debt crisis.
