Dividend equity investing can and should do well even in a rising interest rate environment. This is a new concern with the impact US Fed tapering is having on bond yields. Historical correlations between weekly stock returns and interest movements show that stock prices do well when rates are rising from low levels (5% or below).
Growing dividend payers
Dividends were the big equity market story in the US last year, but they have fallen out of the headlines recently. Investors may have overlooked the fact there have been 310 dividend increases in the S&P 500 this year, with an average increase of 28%. Within the S&P 500, 82% of the names currently pay a dividend – the highest level in 14 years. The payout ratio for the index has started to inch higher and is now at 32% as companies are beginning to feel comfortable paying out a higher proportion of their earnings.
However, the ratio is still well below its long-term average of 49%, suggesting overall payouts are still affordable and the risk of dividend cuts is low.
We think the market has been ignoring the average dividend-paying stocks. If you look at the chart below, it shows the S&P 500 valuations for different dividend quintiles and you can see that the stocks paying out the most are expensive, and so are the ‘low and no’ dividend stocks, but the ones with an average yield look attractively priced by comparison. These average dividend-yielding stocks are in a sweet spot.
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We are not looking for the highest dividend payers in the market, but rather the companies with strong management teams, durable franchises and consistent earnings that can generate sustainable income. Dividends matter, but so does quality. Approximately 75% of the JP Morgan US Equity Income fund is invested in stocks that yield 2%-4%.
Our largest allocation and biggest overweight is in the financial services sector. The earnings of many finance names are depressed by historically low interest rates. As both loan and securities yields increase there should be a dramatic improvement in the profits of most banks, insurers and asset management companies.
One holding that has rewarded us is Wells Fargo. Unusually for a bank it has paid a dividend every year since 1939, and it has increased its dividend five times since the financial crisis. At a current valuation of approximately 11x P/E, it is still cheap relative to its growth prospects and we like the conservative management team.
We also have significant exposure to the consumer discretionary sector, with a focus on US retailers that will benefit from stronger economic growth, such as Home Depot, Williams Sonoma, Dunkin Donuts and others.
