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The Case for Dividend Strategies
The chronic underperformance of dividend payers in recent years has been surprising, as modest GDP growth and low inflation have historically been a favorable backdrop for this investment style. Still, based on a combination of top-down and bottom-up factors, we believe now is the time for investors to own high quality, dividend-paying growth stocks.
We believe investors will increasingly seek exposure to dividend-paying stocks for several reasons. First, due to lagging performance, numerous high-quality dividend-payers now trade at compelling valuations. Second, we believe the U.S. yield curve is distorted by deeply negative term premium and rock bottom rates outside the U.S. and does not signal a looming recession. However, it does reflect an expansion in its later stages and that volatility will rise, adding to the appeal of dividend-paying stocks which tend to perform relatively well in volatile financial markets.
Third, with corporate debt levels at cycle highs and free cash flow growth moderating, investors will increasingly focus on dividends, as buyback activity appears to be peaking. Since valuations for stocks are now at “fair” levels against a backdrop of sluggish corporate EPS growth, incremental returns through dividends will take on greater importance as future stock market gains will likely moderate.
Not all dividend-paying stocks have performed poorly of late, as the most defensive areas of the market (e.g., staples & utilities) have surged, which is typically the case when interest rates fall on rising economic growth worries. Elevated valuations for these “bond proxies” tend to be unsustainable, as an inevitable policy response to growth concerns reverses sentiment and drives down valuations for these stocks. The lagged effect from falling interest rates, Chinese stimulus, and a “pause” in the trade war will tend to favor more growth and cyclical companies within the dividend-paying universe.
We believe there are many compelling investment opportunities in dividend growth stocks across a wide range of industries: financial stocks continue to raise dividends and buy back shares at valuations below market averages; industrial and technology shares should get a boost from a de-escalation in trade tensions; and energy companies are showing increasing restraint on production relative to capital returns. These four sectors currently have solid total yields (dividends plus share repurchases) and, importantly, have significant growth potential.
The appeal of dividend strategies is not confined to large cap U.S. stocks, as many smaller companies also offer attractive growth prospects, with yields significantly above that of the Russell 2000 Index. We believe a “lower risk” strategy is prudent within a small cap universe that is showing increasing signs of speculation – nearly 20 percent of the Index’s capitalization is now comprised of companies with negative earnings, with another 28 percent valued at P/E ratios greater than 30 times. Outside the U.S., dividend yields are generally higher and particularly attractive relative to $12 trillion in bonds trading at negative interest yields. Higher yields, undemanding valuations, and the opportunity to gain exposure to fast growing emerging markets, are key reasons for investing in international dividend growth stocks.
A diversified portfolio of quality, growth-oriented dividend-paying companies can provide investors with an opportunity to participate in market gains, but also provide some downside protection if market fundamentals deteriorate.
Sit Mutual Funds offers three stock dividend growth funds – Sit Dividend Growth Fund, Sit Small Cap Dividend Growth Fund, and Sit Global Dividend Growth Fund.