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These days, savings accounts bear next to no interest, and traditional bonds offer uninspiring yields. So investing in high dividend stocks, boasting returns as high as 10%, has understandable appeal. But those shiny returns could be an illusion. “An investment strategy should never focus solely on dividends,” says Martin Moeller, co-head of Swiss & Global Equity Portfolio Management at Union Bancaire Privée (UBP).
Why are investors so wary? Because the tendency over the past decade has been that companies with the most generous payouts to shareholders underperform the market. On that basis, can a dividend-driven strategy work at all? “Yes,” says Nicolas Simar, senior portfolio manager of Euro and European High Dividend strategies for the Dutch asset management company NN Investment Partners (NNIP). “We can still beat the market with a ‘value-oriented’ portfolio, i.e. under-priced securities that offer better returns in terms of dividends.” Below are a few golden rules to follow in order to do that.
1 - Assess the dividend’s long-term sustainability
To attract investors during its IPO in December 2019, Saudi Aramco pledged to pay its shareholders $75 billion per year. But since the pandemic hit and its revenue has plummeted, the oil giant lacks adequate cash to keep its promises. Now Aramco plans to scale back capital expenditure by 20% to 30% and… issue bonds to raise the funds necessary to cover the dividend payout. “It’s a very bad sign if a company borrows money to pay dividends,” Nicolas Simar says. “Generally speaking, investors should be careful with the sector analysis to make sure that the company’s business model is viable over the long term before they invest.”
Martin Moeller agrees: “The dividend’s sustainability is a key factor. For example, companies such as Shell and BP pay huge dividends. But that may not be the case over the next few years, as the oil industry currently faces major challenges. And its future is uncertain.”
2 - Don’t get caught up on yield
“Focusing excessively on yield leads to bad investment decisions. You should beware of dividends that are high only in appearance,” Nicolas Simar says. “Returns of more than 6% or 7% should be viewed as a red flag, as the risk of cut-off is extremely high.”
Of course, theoretically, companies that pay higher returns have a more attractive dividend policy. But if a company is struggling and its share price drops, yield automatically rises. Due to its unsustainable situation, the company will probably have to reduce its dividend in the years to come.
“Those are what we call ‘value traps’, i.e. companies priced below value that are believed to be good investment opportunities if we only take into consideration share price and dividend,” Nicolas Simar says. “But the share is not actually under-valued and the price will continue to fall. If the dividends don’t at least cover the loss in share value, you lose money.”
3 - Don’t overlook growth
“Companies that pay very high dividends may not have growth plans” says Eleanor Taylor Jolidon, co-head of Swiss and Global Equities at UBP. “For example, a car builder that prefers to pay cash to its shareholders rather than build factories will not grow. Personally, I always prefer growth companies, which create value and whose assets will increase in value.” Telecommunications is another industry that is saturated, with relatively low growth forecasts. Moreover, operators have to overcome a wall of investments with the deployment of 5G.
“A fundamental analysis of companies is essential to avoid dividend traps,” continues Nicolas Simar. “You have to be very selective and choose companies with healthy balance sheets, offering stable, steady growth in cash flow. This reduces the risk profile compared to traditional value strategies, which are not growth-oriented.”
4 - Diversify your portfolio
Many industries, such as banking, oil and insurance, have a reputation for paying out juicy dividends. As a result, dividend portfolios often have a significant sector bias. But lack of diversification can be costly. “In 2008, dividend strategies were overexposed to the financial sector,” Nicolas Simar says. “You’re better off taking a diversified approach and adapting your performance targets to each sector. That way you can combine cyclical stocks, such as Siemens and Schneider Electric, with more defensive sectors like healthcare (in particular Sanofi and Novartis), food retail (Ahold Delhaize and Tesco) and insurance (Zurich Insurance and Munich Re).”
5 - Apply dynamic management
Dividend strategies have long been perceived as defensive, unchanging investments, i.e. grandpa-style investments that contribute a little to the nest egg every year. But times have changed. “We have to be more dynamic now than we used to be,” says Simar. “We generally keep companies in our portfolio for two to three years, to weather structural and technological changes. These days, for example, we like stocks such as Deutsche Post (big winner in the development of e-commerce with its DHL division) and Smurfit Kappa (a leading provider of paper-based packaging highly active in e-commerce). These companies will take advantage of society’s shift towards digital technology to grow, while paying attractive dividends.” Other stocks, such as materials manufacturing giant Saint-Gobain and cement producer CRH, are poised to benefit from post-COVID stimulus packages, with high exposure to the American stimulus programme, especially infrastructure spending.
Back to “value” stocks?
What do Tesla, Amazon, Google and Facebook have in common? These stars of the US stock exchange may drive up quotations, but they pay no dividends to their shareholders. Instead, they pour their profits back into their development. In stock market jargon, these companies are called “growth stocks”. At the opposite end of the spectrum are “value stocks”, securities priced lower than the company’s intrinsic value which generally offer more attractive dividends. For some 10 years, investors have clearly migrated towards growth stocks, with the tech sector being the favourite, abandoning value stocks. This movement has been accentuated further with the pandemic. And dividend strategies have felt the squeeze.
But things could change over the next few months. Bank of America for one expects value stocks to recover in 2021. Nicolas Simar agrees: “The valuation difference between growth and value stocks on the market has not been this wide since the tech bubble of the late 1990s,” says the senior portfolio manager of Euro and European High Dividend strategies for NNIP. “I think the current difference is excessive and expect a correction towards value stocks. Quantitative and fiscal easing policies implemented during the health crisis could support this shift.” But experts still do not agree about the impact on markets, and many investment managers do not expect value stocks to rebound any time soon.