Strengthen Your Core with Dividends During VolatilityBrandon Rakszawski, Senior ETF Product ManagerMarch 10, 2020
The recent volatility in the market and the uncertainty around the impact of coronavirus reinforces the need to be prepared. Tempering volatility, at the portfolio level in particular, can improve the investing experience and help investors weather bouts of turbulence. Most investors would benefit from reevaluating their core portfolio at this juncture, and we believe a dividend investing approach that considers a company’s long-term financial health and valuations may help investors strengthen their core.
Increasingly, many investors are looking to U.S. dividend strategies when constructing their core equity portfolio. They are expanding their search beyond U.S. market beta or active large cap strategies and allocating to dividend strategies for exposure to the U.S. markets with the added potential benefit of increased income levels relative to the broad market.
While core positions often fall short on the excitement factor, their dependability and resiliency create stability. Assets that help protect in down markets while still participating in up markets can deliver a more consistent return stream – one that comforts loss-averse investors and results in higher long-term returns with lower volatility and losses.
Be Selective or Beware
The power of dividends has been proven over the long term, but investors must be discerning when selecting a dividend equity strategy for their core portfolio. After all, total return includes both capital appreciation (the increase in the price or value of assets) and income (in the form of dividend payments). Whether seeking investment in the highest yielding stocks, companies that consistently pay or grow dividends, or a combination of the two, investors are susceptible to the pitfalls of dividend investing, known as “dividend traps.”
The term dividend trap refers to a company that lures investors with impressive, but ultimately unsustainable payouts. Dividends are not guaranteed and even long-time dividend paying companies are susceptible to reducing or cutting their dividends altogether. Unhealthy companies put an investor’s income stream and principal at risk. Financial distress can lead to dividend cuts or suspensions, share price depreciation and bankruptcy.
Additionally, overpaying for yield has become a serious concern. A decade’s worth of steady investor flow to dividend paying stocks paired with U.S. equity markets reaching all-time highs make valuation considerations particularly important. Current valuations do not provide much of a cushion for disappointment, but higher multiples and lower discount rates are not inconsistent with a low growth environment. Buying into stock positions at inflated prices can destroy returns when they revert back to fair value.
Retrospective financial metrics have proven to be a poor gauge of a company’s future earnings performance and dividend sustainability. However, many dividend strategies still rely exclusively on screens for historical dividend payments or historical dividend growth. Selecting companies based on their history of paying is backward-looking and does not account for future prospects.
A more prudent approach also considers business fundamentals. Companies in businesses with secular growth drivers that have clear competitive advantages, low leverage and strong management teams are better equipped to maintainable profit over time—even in a tougher macroeconomic and market environment. Carefully selecting dividend paying companies based on their dividend yields coupled with an assessment of their fair value and balance sheet strength may allow for a portfolio with more potential upside (capital appreciation) while still maintaining an attractive dividend yield (income stream).
The Morningstar Difference
Enter Morningstar’s forward-looking approach to dividend investing. Beyond selecting companies with a high dividend yield, forward-looking assessments of a company’s current valuation and financial health are key components to evaluating the long-term durability of dividend pay-outs and growth potential. The Morningstar US Dividend Valuation Index approaches dividend investing from a position of strength.
Morningstar’s 100-person equity research team assigns a fair value estimate to each company it covers by projecting cash flows well into the future—determining today’s fair value based on tomorrow’s free cash flows. Their estimate of a company’s intrinsic value incorporates an assessment of the company’s economic moat and a projection of the sustainability of its profit potential over time.
Morningstar’s quantitative distance to default score uses current balance sheet and market data to gauge a company’s probability of bankruptcy. It has historically been an effective predictor of future distress and of dividend cuts. Selecting companies with the lowest probability of default helps reduce the likelihood of future dividend cuts.
We Have Been Here Before: Fourth Quarter 2018
Many equity investors were justifiably anxious in the fourth quarter of 2018. Stocks fell sharply and by late December, the strong returns amassed year-to-date evaporated. News headlines warned of imminent recession and amid the noise, it may even have seemed sensible to reduce ones equity allocation.
However, by the second quarter of 2019, stock markets recovered their losses. Despite renewed confidence, many investors were so traumatized by the volatility at the end of 2018 that they stayed on the sidelines in 2019. This decision would prove to be costly.
Driven by high-flying technology stocks of the growth-style persuasion, the S&P 500®recorded positive returns during every quarter of 2019, gaining 31.49% for the year, in U.S. dollar terms. The fear of loss is so great that even in a rising market, the anxiety caused by large market swings can be unsettling enough to prompt investors to make emotional, financially destructive decisions.
Resiliency in Times of Stress
The Morningstar® US Dividend Valuation IndexSM has displayed defensive characteristics versus the U.S. market and other dividend strategies. Most notably, it was down about half of the -14.08% posted by the Morningstar US Market Index in the fourth quarter of 2018.
Case Study: Fourth Quarter 2018 Market Sell Off
10/1/2018 – 12/31/2018
Return Data (%) Fourth Quarter 2018 Return Max
Morningstar US Dividend Valuation Index (Gross of Fees) -6.82 -12.86 Morningstar US Dividend Composite Index -10.88 -16.54 Morningstar US Market Index -14.08 -19.65
Source: Morningstar®. IndexTM performance is not illustrative of Fund performance. Fund performance current to the most recent month-end is available at vaneck.com. Chart content created by Morningstar, does not necessarily reflect the views or opinions of VanEck, and is subject to change at any time based on market and other conditions. No forecasts can be guaranteed.
The possible smoother ride provided by this level of downside protection may be particularly important in the coming months, if not years. Many anticipate persistent volatility due to uncertainty around coronavirus, a potential slowing of the U.S. economy, and heightened political risks during a presidential election year.
Consider a Durable Approach to Dividend Investing
The Morningstar® US Dividend Valuation IndexSM's forward-looking approach of the assessing company valuations and financial health in conjunction with dividend yield stands out in a sea of backward-looking dividend investing methodologies. An investor can access this rigorous research through VanEck Vectors Morningstar Durable Dividend ETF (DURA®), which seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the Morningstar® US Dividend Valuation IndexSM. A durable approach to dividend investing can strengthen an investor’s core portfolio and provide the stability and confidence required to stay in the market during challenging times—reaping the rewards of investing over the long term.
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Authored byBrandon Rakszawski
Senior ETF Product Manager