Some income investors are taking on more risk in this low-interest-rate environment by chasing higher yields. A better approach might be to seek out so-called quality companies with lower, but rising, dividend payouts.
Historically low rates have lasted longer than most people predicted when the Federal Reserve began a series of drastic moves to defend the economy during the financial crisis in 2008. The world remains awash with cash, which means investments with attractive interest or dividend yields keep getting harder to find.
Mike Loewengart, E-Trade’s vice president for investment strategy, said he was alarmed by an increasing trend among investors, even “younger ones in the accumulation phase,” to opt for stocks with high dividend yields.
“People like the comfort of the dividend,” he said. “These stocks or funds or portfolios of high-yielding stocks will have lower betas than the broad market,” he said.
Beta is a measure of price volatility. If a stock has a beta of 1 when compared with the S&P 500 Index SPX, +0.80% for example, its price volatility for the selected period has matched that of the index. Lower beta means less price movement, which might make it easier for an investor to sleep at night. Then again, for an investor with decades to go until he or she needs to draw upon the nest egg being built, significant price swings need to be accepted to enjoy the stock market’s tendency to rise over long periods.
“If you opt for a high-yield portfolio, with ETFs, such as the Vanguard High Dividend Yield ETF VYM, +0.70% you can end up with a portfolio that has considerably different characteristics than the overall market,” Loewengart said.
He added: “You will have defensive sectors, like utilities, that aren’t really positioned for future growth because they are paying out most of their earnings in dividends.” The same might be said for real-estate investment trusts, which are required to pay out most of their earnings.
“So you are overweight these sectors, which can help in a down market, but you can be hamstringing your prospects for future appreciation,” Loewengart said.
A high-yield strategy may be appropriate for some investors who need as much income as possible. However, “in a rising market, you are probably going to lag, so you should really take a broader, longer-term perspective.”
One reason you can lag in a rising market is that the forward price-to-earnings valuations for the highest-yielding sectors are, for the most part, significantly higher than they are for the S&P 500:
S&P 500 sector Dividend yield Price/consensus earnings estimate for next 12 months Energy 3.61% 16.3 Utilities 3.45% 18.3 Real Estate 3.32% 19.2 Consumer Staples 2.96% 19.1 S&P 500 Index 1.99% 16.6 Source: FactSet
So the highest-yielding sector — energy — is the exception. For the other three listed, you are paying significantly more, relative to expected earnings, for the higher yields.
Focus on total return instead
An investor who needs income might find it more efficient and profitable to focus on total portfolio return, Loewengart said.
For example, if your objective is to generate income of 4% from your investment portfolio, 2% of that can come from the dividends provided by the S&P 500 itself, through an index fund. Then, “to make up for that, sell 2% of your position” through the year to get to 4%, Loewengart said.
“The index, of course, doesn’t rise every year,” he said. “Investors have grown quite comfortable during the rising market trend over the past 10 years.”
For 15 years, the average compound annual growth rate for the S&P 500 has been 8.9%. For 20 years, it has been a rather modest 5.9% — but that is still more than enough to support what Loewengart suggested.
This strategy will give an investor more control, which means better tax efficiency.
“With a straight high-yield strategy, you know you are paying taxes on the dividends you receive. If you are using an investment like the SPDR S&P 500 ETF SPY, +0.90% [or the Vanguard S&P 500 VOO, +0.87% for a total return approach with a broad market investment vehicle, you control the taxation — you can defer the long-term capital gain taxes until you need to access the funds,” he said.
A rising income/total return strategy
Loewengart said the total return strategy can be modified with a broad ETF that concentrates on companies with good track records for increasing dividends significantly, such as the Vanguard Dividend Appreciation ETF VIG, +0.70%
A screen for quality dividend stocks
Lewis Altfest, president of Altfest Personal Wealth Management, which manages about $1.2 billion for private clients in New York, said “you should not take the companies with the highest yields. Generally those companies are ones that have weak growth and are vulnerable to dividend cuts, as we saw with Kraft Heinz KHC, +0.94% ” Kraft Heinz cut its dividend by more than a third in February. The stock was down 23% for 2019 through May 10, following a 42% drop in 2018.
For investors who insist on holding individual stocks with attractive dividend yields, Altfest offered some ideas for screening them:
“I would say 3% or more yield, and growth of at least 4% to 5% a year in revenue and profit. And one other element: You want quality stocks with lower volatility — in a beta of 1 or below,” he said.
So beginning with the S&P 500, we narrowed the list:
• Beta for the past 12 months of 1 or less, when compared with the price movement of the entire index: 236 companies.
• Dividend yield of at least 3%: 68 companies.
• Sales increases of at least 5% over the past 12 months: 29 companies.
• Sales per share increases of at least 5% over the past 12 months: 19 companies.
• Then we skipped earnings because of the vagaries of financial reporting. Any company’s earnings for a 12-month period can be skewed by one-time events, accounting changes or noncash items.
We then narrowed the list further to the 15 companies that have increased their regular dividends over the past 12 months. Here they are, sorted by dividend yield:
Company Ticker Type Dividend yield Leggett & Platt Inc. LEG, +1.43% Home Furnishings 4.16% Vornado Realty Trust VNO, +0.38% Real Estate Investment Trusts 3.96% Chevron Corp. CVX, +1.00% Integrated Oil 3.90% Kellogg Co. K, -1.06% Food 3.82% Digital Realty Trust Inc. DLR, +0.15% Real Estate Investment Trusts 3.67% Crown Castle International Corp. CCI, +0.47% Real Estate Investment Trusts 3.58% Regency Centers Corp. REG, +0.67% Real Estate Investment Trusts 3.57% Bristol-Myers Squibb Co. BMY, +0.02% Pharmaceuticals 3.49% Broadcom Inc. AVGO, +2.94% Semiconductors 3.49% Evergy Inc. EVRG, -0.63% Electric Utilities 3.27% Extra Space Storage Inc. EXR, -0.92% Real Estate Investment Trusts 3.25% Public Service Enterprise Group Inc. PEG, -1.38% Electric Utilities 3.17% Genuine Parts Co. GPC, -0.28% Wholesale Distributors 3.09% UDR Inc. UDR, -0.05% Real Estate Investment Trusts 3.09% DTE Energy Co. DTE, -1.00% Electric Utilities 3.00% Source: FactSet
You can click the tickers for more information about each company.
If you see any companies that interest you, the next logical step is to do your own research to get a feel for what is going on. If you believe the company’s business strategy is likely to keep it competitive for at least another decade, you might be looking at a good investment.
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