Dividend-paying stocks are enjoying a renaissance in the face of sluggish economic growth and extremely low interest rates. But pension plan executives should pay close attention to valuations and diversify across a broad mix of sectors — not just traditional defensive ones — in order to tap dividends' full potential and meet funding requirements.
Since the financial crisis, steady income options for retirees and pre-retirees have become scarce at the same time that many pension managers are facing shortfalls and heightened risk aversion. These conditions have fueled renewed interest in companies that reward shareholders with a regular slice of their profits. And for good reason: Dividend payers have a decided performance edge over non-dividend payers, historically. S&P 500 dividend payers, on average, have returned 8.66% annually since 1972 vs. 1.48% annually for non-dividend payers, through June 30, 2012. Dividends have also accounted for 40% of total return during this period.
Moreover, companies that pay a dividend — and display an ability to grow that dividend over time — are generally viewed as healthier and more stable. Plus, their consistent income streams help cushion volatility and offset inflation. These steady payouts also help pension funds meet liabilities and mandated return targets at a time when the threat of a shortfall looms large. Indeed, two nasty bear markets — in 2000 and 2008 — have created wider funding gaps as millions of Americans near retirement. Some consultants are now projecting as much as a 2% shortfall per year for the next decade.
What's more, pension managers looking to offset risk through exposure to fixed income assets are being punished by an aggressive monetary policy. The Fed is essentially forcing them to take risk by pegging its target rate near zero until mid-2015. Meanwhile, the recovery has slowed and capital markets are in flux. With income and growth so scarce, stretching for yield without regard for price/earnings multiples puts pension return targets in jeopardy.
In pursuit of income, institutional investors should be wary of focusing only on sectors that have historically paid out the highest dividends: telecom and utilities. A lot of these defensive stocks were bid up in 2012 and are now looking fairly frothy. Among S&P 500 telecom companies, the average P/E is 19.06 vs. a 10-year average of 15.74. This crowding has prompted some market observers to suggest a dividend bubble.
However, when you canvass the broader spectrum of dividend-paying stocks, it's easy to see that only a portion of them are too richly valued. More troubling, perhaps, is that many investors have become yield chasers. They want the highest yield possible along with some stability. If they can't get it in bonds, then utilities and telephone companies are the next best thing. And that's what's been happening: More money has been lost reaching for yield than any other way in the market.
For bottom-up stock pickers, diversification is crucial. It's important not to confine dividend exposure to the traditional high-yielding sectors. There are myriad places to find yield outside of telecom and utilities. In fact, valuation should be considered first and foremost. Instead of chasing yield, seek high-quality value stocks that pay dividends. Don't restrict your universe. Span the economy to find solid companies with strong balance sheets that aren't getting their due. The sweet spot? Companies with stable or increasing free cash flow that are gaining market share and have little or no debt — they will be able to increase their dividends over time.
Marrying dividends with a low-P/E value strategy allows you to get paid to wait for markets to realize that certain companies are undervalued. But when it comes to choosing the right dividend-paying stocks, it also pays to do your homework. Sector rotation is a recipe for failure. Rather, buy stocks that pose attractive opportunities from a valuation and yield perspective, particularly companies with strong balance sheets and cash flows. Right now, that should lead investors toward cyclical companies and away from more defensive areas of the economy. Over full market cycles, balancing low valuation with dividend yield is a powerful combination.
To be sure, looking outside the typical high-yield, low-growth areas, investors can still find attractive yields. Many oil companies are paying a 4% yield and raising their dividends. A lot of health-care stocks are trading under 10 times earnings and have solid dividend yields. Additionally, we're starting to see dividend hikes in financials, where a lot of beaten-up banks' payouts had been artificially capped by regulation.
Elsewhere, tech is poised for strong dividend growth too. Across all sectors, tech boasts the fastest growth in dividends over the past five years. Yet, it still has low dividend payout ratios and the most cash. And it's cheap: S&P 500 tech stocks, on average, are trading at a P/E of 13.08, well below their 10-year average of 21.93.
Overseas, Brazil is an attractive place to find dividends. Its 4% average dividend yield is double what you'd find in other BRIC countries, and it's trading at a steep discount to its historical P/E. Japan is also undervalued and has rising dividends.
Ultimately, a key advantage of dividend investing is positioning portfolios for positive real returns, particularly in tough times. We're mired in low growth with record-low interest rates, or “financial repression.” Investors seeking a safe haven who pile into bonds are hurting themselves by relinquishing their purchasing power. Investors shouldn't pay the government to hold their money. If they do, then they're accepting 1.6% yields from Treasuries when there is 2% inflation, effectively locking in a negative return. Dividends, however, have grown 5% per year over the past 50 years — about 1% per year above inflation. That's made dividend-paying stocks less risky than bonds for income-focused investors.
Hampered by financial repression, stock-market returns are likely to be lower than their long-term average, which suggests a more prominent role for dividends in total returns. Looking closely at valuation across multiple — and less obvious — sectors and geographic regions will boost the quality of dividend exposure.
Ben Fischer, based in Dallas, is a managing director and portfolio manager at NFJ, a company of Allianz Global Investors.