What Next for Dividend Paying Stocks?

Morningstar analyst Jeffrey Schumacher outlines what income investors can expect in the coming months

Jeffrey Schumacher 6 August, 2013 | 11:24AM
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Dividend investing has been a popular investment style over the past three years as the search for yield drove investors into high yielding stocks. This search for yield was caused by a combination of factors such as changing demographics, low interest rates, uncertainty and low economic growth. These have fueled investors’ appetite for dividend paying stocks. Morningstar data shows that assets under management within the Global Equity Income category have risen sharply from EUR 8.5 billion in January 2010 to EUR 46.8 billion as of May 2013.

Of this amount, EUR 26.8 billion is attributable to inflows, but this also indicates that dividend stocks have rallied since 2010. Consequently, there are signals that specific areas of the high dividend universe are becoming too expensive. From this perspective, the hunt for income looks more like a scream for yield rather than a search for yield. Besides valuation concerns, dividend sustainability remains an issue, even for traditional dividend sectors. Finally, the possible tapering of QE3, the monthly $85 billion stimulus program of the Fed at the end of this year is another source of concern. The possibility of rising interest rates could affect financial markets and dividend stocks in particular. These trends point to a possible change in the dividend game.

Traditionally, dividend funds have a bias to high yielding sectors such as telecom, utilities, real estate and financials. Although a high yield is an attractive feature, it can also be a warning signal, especially for dividend investors. This became reality in 2008 when financials tumbled and dividends were either cut or, in some cases, scrapped altogether. The once reliable cash machines were no longer the cornerstone of dividend portfolios.

Defensive dividend investors learned the hard way, as the average loss of the Global Equity Income category in 2008 was 38.4%, even more than the loss of 37.6% for the MSCI World index. Dividend sustainability was an issue again in 2012, when dividends of telecom companies came under pressure. High debt levels, falling margins and capex requirements and depressed cash flows caused a number of once dependable European telecom giants like KPN and Telefónica to cut their dividends.

After Fed chairman Ben Bernanke’s June 19 announcement signaling the end of QE3, markets became nervous again. The yield on a 10-year US Treasury Note rose above 2.5% for the first time since 2011. This fueled the fear that with time dividend yield will become less attractive for yield searching investors as yield becomes less scarce, potentially resulting in contracting multiples for dividend stocks.

Interest rates are also affecting dividend stocks from an earnings perspective. Rising interest rates affect all business models and companies that use significant financial leverage. Telecom, utilities and real estate stocks are arguably under pressure as these stocks are perceived to be the most vulnerable to a rise in interest rates. Earnings and dividends can come under pressure, which reduces the dividend sustainability of these stocks.

From a style perspective, things can also change. In the past three years, the combination of quality stocks and dividends was a winner, while value investors had a difficult time. The uncertainty in financial markets drove investors into quality growth stocks -- that is companies with strong business models, strong cash flows, sound balance sheets and quality management. Quality stocks have become more and more expensive, but the value style has historically performed well in the stage of earnings recovery. So far this year, value strategies have performed better, so is it time for a change?

One can conclude that the current market situation is challenging for dividend investors and various factors affect the positioning of a dividend portfolio. At Morningstar we have a high regard for capable fund managers who have invested over a full market cycle and have proven adept at coping with changing market conditions, while still sticking to their investment process and philosophy.

A clear example of this is the Gold rated Veritas Global Equity Income fund. We hold managers Charles Richardson and Andrew Headley in high regard. The two have been responsible for the fund since 2005 and have previously worked together at Newton. They also benefit from the support of an experienced team of five analysts, whose research is instrumental to this fund's portfolio. The fund's standout characteristic is the extent to which the managers aim to deliver real returns to investors. They invest in companies with durable competitive advantages and strong, sustainable cash flows that can lead to dividend payments. Yield is one of the considerations, but the managers are not prepared to invest in high-yielding companies that are unlikely to contribute to capital growth. Finally, they also use a thematic framework to help identify industries globally that they believe will benefit from long-term structural drivers. We think this fund remains a strong choice for investors seeking a growing income from a global equity portfolio. Indeed, the consistency with which the managers have achieved the fund's returns makes it stand out amongst its peers.

Another fund that has a quality team of managers is DWS Invest Top Dividend. This Silver rated fund is managed by Thomas Schüssler and Oliver Pfeil. They are backed by a team of eight members. Schüssler's experience and expertise, together with the extensive resources at his disposal, are convincing. The aim of the investment process is to identify companies that pay dividends in a sustained manner. Ideas are generated by means of quantitative screening. The fundamental analysis that follows is based on the assessment of annual reports, manager meetings and various valuation models. Due to the dividend orientation, the fund manager ultimately gives preference to companies with superior business models. This means that Schüssler generally invests in quality stocks from the mega-cap universe that stand out thanks to their strong cash flows. He mixes equities with different levels of dividend return. The core is formed by stocks with dividends that historically show a steady increase, such as Nestle, Coca-Cola or Philip Morris, whose dividend level is more at the lower end of the targeted bandwidth. Equities from various sectors with relatively high dividend returns are added to these. This mix is rounded off with stocks for which dividend growth is the primary focus.


This article originally appeared in Professional Adviser on August 1

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Jeffrey Schumacher  is a Fund Analyst with Morningstar Benelux.

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