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Equity Perspectives

A dividend-growth strategy may provide the stable, increasing income stream many investors need.

Investors have struggled to find income when interest rates are close to, or even below, zero. Current and prospective retirees feel this struggle most acutely. Many have built substantial investment portfolios, but lack the income to comfortably fund the expenses of retirement. The roots of the low-yield problem include sluggish economic growth and low inflation estimates—something bond yields are implying will continue for decades into the future.

On top of that, major central banks continue to bid for bonds in order to stimulate demand growth, a strategy that’s shown limited effectiveness thus far. The results have been striking: the yield on the 20-year U.S. Treasury bond has fallen, to 1.95% (as of September 2), from more than 3% only two years ago, according to U.S. Treasury data. And that’s extravagant compared with the yield of 0.28% on the 20-year German government bond, as reported by Bloomberg.

As a result, many investors are turning to equities for income. Chart 1 shows that (as of July 31) more than 60% of companies in the S&P 500® Index featured dividend yields greater than the yield on the 10-year U.S. Treasury note—a rare event that in the past was precipitated by falling stock prices, as occurred in 2008 and 2011.

 

Chart 1. Many Stocks Recently Provided Higher Yield Than the 10-Year U.S. Treasury Note
Percentage of S&P 500 stocks with trailing 12-month dividend yield greater than 10-year U.S. Treasury yield, January 1, 1986–July 31, 2016  

Source: BofA Merrill Lynch U.S. Equity and Quant Strategy, Standard & Poor’s, and Bloomberg.
Past performance is no guarantee of future results. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

This time, the yield advantage of equities is a little different and, arguably, more sustainable, because the spike in dividend yields has been caused by persistent­ly low bond yields and an increasing proportion of companies paying dividends. Note that 73% of the companies in the Russell 1000® Index paid a dividend in 2015, a substantial increase from 63% in 2010, according to FactSet. There is no doubt that dividends have been embraced by companies and investors alike. As we have noted in the past, a dividend focus helps keep company management disciplined and is highly valued by shareholders seeking yield.

Unfortunately, however, dividend investing and dividend payments can go out of favor—especially when times become difficult. One example is the financial crisis of 2008–09. Profits dropped and companies became focused on liquidity, survival, and debt reduction instead of making dividend payments. Chart 2 shows that from 2008 to 2010, the dividends paid by companies in the S&P 500 dropped 23%.

 

Chart 2. In the Broad Stock Market, Dividend Payments Have Waxed and Waned Over the Years
Dividend (in 2016 dollars) on the S&P 500 Index, 1915–2015 

Source:  Standard & Poor’s and Robert Schiller database at www.econ.yale.edu.
Past performance is no guarantee of future results. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

On the flip side, good economic times also can slow the growth of dividend payments, and may even cause them to fall. Companies may see stock buybacks or acquisitions as a better use of cash, and also may re­spond to investor preferences for capital expenditures and organic growth. We saw this most recently at the end of the 1990s, when growth investing gained favor and dividends suffered. In both situations, some com­panies that recently adopted a dividend-payout policy simply stopped paying dividends or cut payouts.

For an investor trying to build a portfolio that provides consistent income, dividend cuts are a major problem. This poses an additional risk to equities, on top of their potential for loss of principal. Compounding the problem is that stock prices and dividends most often go down together. An investor relying on equity dividends for income may then be forced to sell principal when prices are low, which rarely is a good strategy and one that can lead to financial ruin under certain circumstances, a situation commonly described as sequence of returns risk.

Chart 3 illustrates this risk via two retirement scenarios. Each portfolio, over a period of 20 years, earns an aver­age nominal annual rate of return of 7.5%; but the gold line in the chart represents a scenario in which negative returns are clustered early on during retirement. Because the investor is liquidating principal at low prices for income needs, the portfolio isn’t able to bounce back sufficiently, despite strong returns in the following years.

 

Chart 3. Sequence of Returns Risk Can Harm Returns for Investors Who Depend on Portfolio Distributions
Portfolio market value for two sample portfolios over 20 years, with a starting value of $1 million, based on scenarios listed below

Source: Lord Abbett.
Note: This chart looks at the effect the sequence of returns can have on your portfolio value over a long period of time. Other factors that may affect the longevity of assets include the investment mix, taxes, (federal, state or municipal), and expenses related to investing. If these were taken into account, the hypothetical values shown may be different. This is a hypothetical illustration. This illustration assumes a hypothetical initial portfolio balance of $1,000,000 with no additions and withdrawals of $60,000 a year for 20 years. Each portfolio earns identical 7.5% average nominal annual rates of return over 20 years; the gold line represents a scenario in which negative returns are clustered early on in a retirement.
Past performance is no guarantee of future results. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

Portfolios focused on companies with a consistent record of increasing dividends in each calendar year have the potential to substantially increase the safety of dividend income. We use a 10-year period as a barometer of consistent dividend growth because such an interval typically includes one or more significant economic or market downturns. Companies that have raised dividends every year, through good times and bad, do not do so by accident. These companies must have the ability to raise dividends every year, which would mean that they typically are high-quality firms with strong, growing, and stable businesses. They also have signaled the intention to raise dividends every year—a characteristic that becomes part of their corporate identity. The next time an economic crisis occurs, we can anticipate that they will respond in the same way they did to the last crisis: they will raise their dividend.

Lord Abbett worked with S&P Dow Jones Indices to create an index tracking dividend-growth stocks; it is called the S&P 900© 10-Year Dividend Growth Index, comprised of the companies in the S&P 500 Index and S&P MidCap 400 Index that have raised dividends in each of the last 10 years. Chart 4 shows the dividend payout of this index (in gold) with no reinvestment, since 2005 relative to the S&P 500 payout with no reinvestment, in gray. Most notably, this chart shows that between 2008 and 2010, when the S&P 500 cut dividends by 23%, S&P 900© 10-Year Dividend Growth Index continued to raise dividends: 4% in 2009 and 4% in 2010.

 

Chart 4. A Dividend-Growth Portfolio Historically Has Provided a More Consistent Income Stream Than the S&P 500
Annual dividends received from a $100,000 investment, 2005–15

Source: Standard & Poor’s. Dividend growers represented by the S&P 900 10-Year Dividend Growth Index. The Dividend Growth Index is the exclusive property of S&P Dow Jones Indices LLC. Under a contract with Lord Abbett, S&P Dow Jones administers, maintains, and calculates the Dividend Growth Index. S&P Dow Jones and its affiliates shall have no liability for any errors or omissions in calculating the Index. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is no guarantee of future results. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

This characteristic can be a game-changer that allows investors to use a dividend-growth equity strategy to address income needs. While price volatility will always exist, a portfolio that has demonstrated this kind of consistency in income growth can compete head-on with fixed-income offerings—and provide distinct advantages. The dividend-growers index had a portfolio yield of 2.5% (as of September 2), compared to a 1.95% yield for the 20-year U.S. Treasury bond, according to Bloomberg. Over the last 10 years, that dividend-growers index has increased its payout by 82.7%, or 6.2% per year—and the payout never went down on an annual basis. So, in 20 years, if historical trends are any indi­cation, we could project the dividend-growers index to yield around 8.3%, based on today’s cost (i.e., the origi­nal amount invested). And this is without reinvestment, meaning that this yield on cost is realized even after the entire dividend payout has been taken in each year.

And the 20-year Treasury? The yield on the original amount would have stayed the same over the course of the investment, leaving the investor with a yield of 1.95% after two decades. So, as a solution for current and future income, a dividend-growth portfolio has tremendous potential merit.

Of course, the principal risk of an equity portfolio is greater than an essentially “risk-free” U.S. Treasury investment. But how likely are we to have less principal in a portfolio of high-quality, dividend-paying U.S. equities 20 years after we started? Since 1931, 20-year principal growth of the U.S. stock market (as measured by the S&P 500) has averaged 366%, with no 20-year periods of price declines in that time. Extending the analysis back to 1871, there have been some 20-year periods with price declines, but the average return is still 211%, and more than 92% of the 20-year periods have positive principal growth.

Because an investor receiving a consistently growing income stream may not have to dip into principal, the shorter-term volatility of market-price returns is less important. In addition, because sequential dividend growers typically are high-quality companies, the prices of these securities historically have been less volatile than the market indexes. In the event an investor has to sell principal during a difficult market environment, a dividend-growth portfolio could help protect that principal better, with, for example, an average of 83% downside capture in the largest peak-to-trough market declines in the last 10 years, as shown in Table 1.

 

Table 1. Dividend Growers Have Outperformed in Market Declines
S&P 500 Index return and downside capture of the S&P 900 10-Year Dividend Growth Index during the 10 largest intra-year periods of S&P 500 declines since October 10, 2007

Source: Bloomberg and Lord Abbett. Maximum intra-year declines; start dates inclusive.
1S&P 900 10-Year Dividend Growth Index.
The Dividend Growth Index is the exclusive property of S&P Dow Jones Indices LLC. Under a contract with Lord Abbett, S&P Dow Jones administers, maintains, and calculates the Dividend Growth Index. S&P Dow Jones and its affiliates shall have no liability for any errors or omissions in calculating the Index. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is no guarantee of future results. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

The consistency of income and price stability that a dividend-growth strategy provides allows an investor to realize the reliable price and dividend growth of the market over long periods. The income stability, in particular, makes this a unique asset class that can help investors who need reliable income, while providing a significant advantage in reliable dividend growth and likely principal growth. In a world where yields on many investments are expected to remain “lower for longer,” this strategy, we believe, becomes especially compelling.

 

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The Lord Abbett Series Fund Calibrated Dividend Growth Fund invests in stocks of large U.S. companies that have a history of increasing dividends.

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