How to Select Dividend-Paying Stocks

Chasing yield can lead investors to risky corners of the market. The past decade is littered with instances of dividend traps

Dan Lefkovitz 20 July, 2018 | 9:16AM
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Investors across the globe prize dividend-paying stocks for both income and total return. Dividends demonstrate balance-sheet strength and a commitment to shareholders. Studies show that reinvested dividend payments contribute a substantial portion of long-term equity market returns.

Several academic studies have pointed to the long-term performance advantage of dividend-paying stocks. Yield is sometimes identified as a “factor”, a driver of excess return, while others believe that dividend payers do well because they tend to occupy the lower-priced portion of the market.

In any case, the track record is strong. Investing in the high-yield portion of the equity market tends to be a winning strategy across the globe. Meanwhile, non-dividend payers underperform the market.

Why do dividend-paying companies outperform? Several factors are likely at play. Dividend payers tend to be established, steadier-than-average companies, confident enough in their cash flows to commit to returning cash to shareholders. Because investors are extracting income from their stock holdings, they are less likely to sell on bad news. Shareholder loyalty dampens volatility.

Beware the Risks

But dividend investing is far from risk free. Interest rates are widely viewed as the principal nemesis. A bigger risk is 'dividend traps', stocks with enticing yields that proceed cut their pay-out or scrap it entirely.

But dividend investors can avoid these traps with the help of the Morningstar Economic Moat Rating and other proprietary metrics.

Chasing yield can lead investors to risky corners of the market. The past decade is littered with instances of dividend traps, such as financial services stocks in 2008-09 and energy and materials in 2014-15.

Investors reliant on backward-looking indicators, such as a company’s dividend-paying history, have been burned. Companies can be reliable payers – until they’re not.

In 2010, Morningstar designed a uniquely forward-looking approach to rules-based passive equity income investing: the Morningstar Dividend Yield Focus Index. At the time, we showed that proprietary metrics can screen out companies at risk of cutting their payout.

In our latest paper, we found that Morningstar’s metrics for quality and financial health have global utility for dividend investors. The Morningstar Economic Moat Rating is assigned by equity analysts to 1,500 companies globally. It describes the strength of a firm’s competitive position, gauging the sustainability of profits that ultimately are returned to shareholders in the form of dividends.

The Distance to Default analyst metric gauges financial health, forecasting the likelihood of bankruptcy.

In each region, the trend was the same. The wider the moat and the higher the Distance to Default score, the less likely for a company to cut its pay-out. By screening the dividend-paying universe for these metrics, the Morningstar Dividend Yield Focus Index family focuses on sustainable yield. It offers a selective, forward-looking approach to equity-income investing.

Interest Rates and Dividend Stocks

Intuitively, higher interest rates make cash and bonds more attractive relative to dividends. For this reason, dividend payers often take a hit when rates rise. But longer term, does equity income struggle in higher rate environments, and vice versa?

We examined the relative performance of dividend-paying stocks in different interest-rate environments. We looked at returns for higher dividend payers against the 10-year government bond yield in several markets, the US, the UK, Germany, Japan, and Australia.

high yield equities vs interest rates UK graph

The results for the UK, demonstrate no clear pattern. In some periods of rising rates, high-yield equity outperformed and vice versa. In other regimes, the conventional wisdom was borne out. 

This pattern holds across markets studied. The wider context matters. Dividend investors should fret less about interest rates and more about moats.

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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About Author

Dan Lefkovitz

Dan Lefkovitz  is strategist for Morningstar’s Indexes group

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