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Market View

Investors may want to consider a balanced approach that more accurately reflects the landscape of dividend paying stocks.

In recent years, many investors have turned to the equity market to meet their income needs. However, some investors may be adhering to an outdated perception of where dividends can be found, and in doing so are introducing a variety of unintended risks into their portfolios.

When some investors picture a dividend-paying stock, a certain type of company may come to mind: a mega-cap, slow-growth company that returns a large portion of its earnings to shareholders—perhaps a large utility or telecommunications company. However, an unbiased look at where dividends can be found in the market today shows that this view represents only a small slice of the opportunity in dividend paying stocks.

We have discussed in the past why it may not be appropriate to use bond proxies as a representative for all dividend paying stocks and the risks this may introduce into an equity income portfolio, specifically interest-rate risk. But why does over-allocating to these stocks expose a portfolio to interest-rate risk? Why are these stocks called "bond proxies"?

When analyzing a stock, it is not just important to understand the growth of a company’s earnings but also what it chooses to do with those earnings. Essentially, a company has three options: share the earnings with shareholders through a dividend; buy back shares; or reinvest those earnings into the company (research and development, mergers and acquisitions, for example) to spur further growth. The dividend payout ratio is a useful metric to help investors understand how a company puts its earnings to use. The dividend payout ratio frames a company’s dividend paid to investors in relation to the company’s total earnings: the higher the dividend payout ratio, the greater portion of the company’s earnings that is paid to investors.

The returns of a company with a high payout can be essentially bond-like (hence, the bond proxy moniker) if the earnings of the company are not particularly sensitive to economic growth, as often is the case for regulated utilities, telecom, and some consumer staples, for example. (See Chart 1.) This type of investment certainly has benefits for some types of investors, but for those searching for a growth and income mandate, an overconcentration in bond proxy investments introduces new risks into an equity portfolio, with interest-rate risk being the major one.  The income stream of a company with a high, fixed payout would face headwinds in an environment where interest rates and inflation expectations moved upwards, as its stable earnings and dividends would be discounted at a higher rate. On the other hand, companies that pay a dividend but have a lower dividend payout ratio are usually more leveraged to economic growth. As the economy improves, the prospects for higher returns on earnings reinvested into the company also grow stronger. This can help offset, and in many cases even negate, the detrimental impact of rising interest rates and inflation on the income stream.

 

Chart 1. Dividend Payout Ratios Vary by Sector
Five-year average dividend payout ratio by sector in the Russell 1000 Index, 2012-2016

Source: FactSet, data as of 12/31/2016.For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett portfolio or any particular investment and are not intended to predict or depict future results. 

 

This is an important consideration when investing in dividend-paying stocks, because we have seen the definition of equity income change over the last 10 years. The landscape is no longer dominated by bond proxies; in fact, those sectors commonly referred to as “bond proxies” represent less than 25% of all dividend-paying stocks in the Russell 1000 Index. One way to visualize the changing landscape of equity income can be found by looking at the sector distribution of all dividend-paying stocks over time. Chart 2 shows that today, more dividend-paying stocks can be found in the information technology sector than in the utilities sector, and that the opportunity has changed fairly rapidly over the past several years.

 

Chart 2.  The Evolving Landscape of Where Dividends Can Be Found
Distribution of dividend paying stocks in the Russell 1000 Index by the indicated sectors, 2007–2016

Source: FactSet, data as of 12/31/2016. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment and are not intended to predict or depict future results. 

 

And it is not just the number of dividend payers that has increased. Chart 3 shows that the average yield of companies in two sectors that were perhaps not historically associated with dividends has increased meaningfully over time.

 

Chart 3. Yields of Consumer Discretionary and Tech Companies Have Grown Steadily
Dividend yield of the indicated sectors in the Russell 1000® Index, 1999–2016  

Source: FactSet, data as of 12/31/2016. For illustrative purposes only and does not represent any specific Lord Abbett product or any particular investment and are not intended to predict or depict future results.  Past performance is not a guarantee or a reliable indicator of future results.

 

We are not advocating attempts to predict sector performance or shift allocations based on forecasted interest-rate moves. But we believe that many investors would benefit from updating their definition of equity income and employing a balanced approach that more accurately depicts the landscape of dividend-paying stocks. Such an approach may mitigate risks that broadly affect certain groups of stocks and instead focus on generating returns through identifying mispriced securities.

 

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Historically speaking, growth and value investments tend to react differently during the economic cycle. Since value stocks are often cyclical in nature, they may benefit from the increased spending that usually occurs during an economic expansion. Growth stocks may also perform well during an expansion, but they may also be out of favor during market downturns, when investors pay more attention to price ratios. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. No investing strategy can overcome all market volatility or guarantee future results.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a guarantee or a reliable indicator of future results.

The Russell 1000® Index  measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The dividend payout ratio measures the proportion of earnings paid out to shareholders as dividends. The ratio is used to determine the ability of an entity to pay dividends, as well as its reliability in doing so.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

FEATURED STRATEGIST

RELATED FUND
The Lord Abbett Affiliated Fund Class A invests primarily in dividend-paying stocks of large U.S. companies. Access performance and portfolio information.

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