Dividend quality in action

Jul 21st, 2020 | By | Category: Equities

By Chris Huemmer, Senior Vice President and Senior Investment Strategist for FlexShares ETFs.

Chris Huemmer, Senior Vice President and Senior Investment Strategist for FlexShares ETFs.

Chris Huemmer, Senior Vice President and Senior Investment Strategist for FlexShares ETFs.

Since the beginning of March 2020, dividend payments have been slashed as companies are faced with a combination of sharply declining revenues and regulatory restrictions.

The Wall Street Journal cited in April that investor expectations for dividend payments, as priced in dividend futures, are indicating a decline of 20% for the S&P 500 Index over the next 12 months.

As of recent, 81 US companies and public investment funds (including REITs) have suspended or canceled their dividends, the highest number since 2001.  For investors that rely on dividend income, this could create a significant problem.

There are, however, ways to potentially insulate your portfolio from cuts that are disproportionately impacting specific sectors, or comparatively less-solvent companies. For investors looking to maintain a healthy level of potential dividend yield in the current environment, we believe they should consider a “DIA” approach:

  • Diversify the source of dividends across sectors and regions
  • Integrate an empirically driven and multi-dimensional measure of quality
  • Avoid strategies that focus on dividend track records as a component of underlying index construction and ignore delivering yield in excess of market-weighted indices

Diversify the source of dividends

Historically, high dividend-paying companies tend to be focused in mature industries and hence are concentrated in certain sectors. Our research suggests that half of the MSCI World Index dividend yield comes from four sectors: Financials, Industrials, Consumer Discretionary, and Energy.

Relying heavily on one sector for dividends can be a recipe for disaster, as was observed during the Global Financial Crisis in 2008 when companies within the Financial sector experienced a dividend reduction of 60%.

We believe that a high-income portfolio that diversifies its sources of income and, therefore, may help avoid unintended sector bias is essential to minimize the potential adverse impact of dividend concentration.

Source: FlexShares ETFs.

Source: FlexShares ETFs.

Consider a quality plus approach

Historically, a successful dividend investing strategy has been about identifying companies that consistently paid dividends and increased them over the long term. Seeking out dividends without considering a company’s future ability to maintain them is akin to buying high yield debt without considering its likelihood of defaulting on interest payments.

But many times, a higher dividend yield is the result of a decline in a security’s overall price. These seemingly “cheap” high-yielding stocks may be yield traps where the price decline makes them attractive from a yield perspective but only in the short-term because the market may be pricing in the impaired fundamentals that may precede dividend cuts or worse, bankruptcy.

We argue that investors should take a “Quality Plus Approach,” which is to consider companies that have sustainable competitive advantages and have generated sustainable shareholder value over time. Assess the sustainability of payouts by measuring characteristics, including strong profitability, consistent and strong levels of cash flows, and prudent deployment of capital by an efficient management team.

Source: FlexShares ETFs.

Avoid strategies that require dividend payment or dividend growth history

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FlexShares Quality Dividend Index Fund (QDF US)

  • Designed to avoid common risks of dividend
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  • Tracks the Northern Trust Quality Dividend Index,
    which applies a proprietary, multi-faceted Dividend
    Quality Score (DQS) to measure a company’s core
    financial health and evaluate whether it may increase
    (or decrease) its future dividends.
  • The DQS score evaluates dividend-paying equities on
    the basis of management efficiency, profitability, and
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  • QDF houses $1.3bn AUM and comes with an expense
    ratio of 0.37%.

Some strategies, perhaps as an attempted proxy for quality, may use historical consecutive dividend payments or dividend growth as criteria for index inclusion. Even in better economic conditions, we believe there is a better way than requiring a 10- or 20-year history of consecutive dividend payments or dividend growth, which may exclude newer dividend-paying, healthy companies and disproportionately impact certain sectors.

Our concerns about approaches that rely on dividend payment history are amplified in an environment where companies may be reducing or eliminating dividends, even on a temporary basis, as those funds may see their eligible investment universe shrink considerably, and potentially for many years. Further, strategies that use dividend payment history as a proxy for quality may have to sell positions following a dividend cut as they had no potential means of predicting a company’s likelihood of actually continuing to pay a dividend.

Instead of presumably using a dividend payment history or a history of increasing dividends as a proxy for quality, we recommend using a multi-dimensional definition of quality, and potentially sourcing yield from a broader swath of the economy.

Through a carefully constructed approach that sources income from all parts of the equity market and pays close attention to company fundamentals, we believe that investors can maintain healthy dividend yields even in this environment.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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