The past few years have not been easy for investors around the globe. We have been hit by a number of crises at once, and the coming years will bring fresh challenges. Therefore, we want to examine the claim that dividend stocks are immune to crisis.
The current political and economic situation we find ourselves in can be called a polycrisis. Within a few years we have been through a trade conflict between the US and China, a global pandemic and an invasion in Europe with far-reaching consequences for energy policy. In addition, we are seeing a new race between political and economic systems with implications for global trade and supply chains. Concerns over the banks have recently resurfaced and have led to emergency acquisitions and supports by central banks.
In addition, industry’s energy transition to sustainable energy sources as well as demographic change are leading to higher inflation. The days of lower inflation rates and interest rates, and global free trade are over. Investors have to consider these changes in their investment strategy in order to secure their capital for the years ahead and obtain an adequate return after inflation. With all this in mind, we want to take a look at dividend stocks and highlight their advantages.
The first acid test for dividend stocks came in the form of the global pandemic. Production and supply chains ground to a halt worldwide and day-to-day life became filled with uncertainty. The global pandemic was the first challenge facing dividend stocks since the financial crisis. To remind readers, after the financial crisis, it was 2013 before dividends in the STOXX Europe 600 hit record highs again. After the record year for dividends in Europe in 2019, fresh highs are already expected this year. In the US, there were even record-breaking dividends in the S&P500 in all quarters back in 2022.¹ So the data show that companies are prioritising paying out dividends to investors more than in previous crises.
There are a number of reasons for this. Dividends are companies’ way of signalling to the capital market that while they are expecting an economic slowdown they basically still have a successful business model with reasonable profitability and a solid balance sheet. They signal that they want investors to continue to participate in the company’s success regardless of short-term movements in share prices. For 2022, Janus Henderson expects dividend growth of 8.4% to USD 1.56 trillion – a new record.² In regional terms, North America and Europe are the biggest contributors to this figure, at 40% and 22%, respectively. It is essential for investors to be exposed to both regions in order to generate a reasonable return.
The importance of dividends is on the rise again against the backdrop of higher inflation and interest rates. Over time dividend growth compensates for inflation! In 2022, dividend growth in Europe excluding the UK was 11.2% and in North America 10.2%. In the same period, inflation averaged 8.1% in Europe and 7.9% in the US.³ Of course, in an environment of rising interest rates, we shouldn’t let perfect be the enemy of good. However, it must also be said that the interest rate level, which is higher at the moment, generally does not exceed inflation rates. If investors want to preserve or grow their capital in real terms, dividend stocks should be a linchpin of their strategy. In addition, dividends are a major contributor to total return. One example is the difference between the DAX price index and the performance index (which includes dividends), which is almost 60% in the past 20 years alone.
Investors value dividend stocks in times of volatility because of their defensive quality. Traditional dividend-paying stocks have business models that generate high cash flows and have robust balance sheets. Dividend funds are generally less volatile than the broad equity market on account of the disproportionately higher weighting of companies with strong cash flows. However, there are a few pitfalls to avoid when selecting dividend stocks. Investors should not be fooled into looking at absolute targets when it comes to dividends. Companies should be selected based on a holistic approach in order to promote long-term business success and thus also ensure dividend continuity and level.
Companies that pay dividends out of the company’s assets are unsuitable investments, as are companies with business model undergoing structural changes. We are currently seeing problems like this with real estate stocks due to rising interest rates. Real estate stocks benefited greatly from construction activities and cheap finance in the zero interest environment but are now seeing business slump due to inflation in construction costs and rising interest rates. The latest events are likely to take a toll on banking stocks as well. Even in this economically challenging year, we are still expecting dividends to be stable or increase slightly. We think that even if the situation deteriorates – which we think unlikely – share buybacks will be reduced rather than cash dividends.
In this fast-changing environment, we find it important that companies and their management teams are able to adapt quickly to altered circumstances. In the case of good companies, this adaptability leads to market share gains and also to a sustained increase in the value of the company. Not only do the strong get stronger, but so too do the fast!
Lastly, we want to complete the traditional picture of dividend stocks with a look at small and mid caps (SMEs). Traditionally, we find dividend-paying stocks in defensive sectors like food and beverage. If investors focus too much on these sectors, they will miss exciting opportunities to earn dividends. SMEs are generally more dynamic and offer higher dividend growth, which the share prices reflect in the medium to long term. We prefer family-run companies due to their long-term orientation and the fact that family members have large shareholdings, which aligns their interests with those of other shareholders. Periods of volatility especially, such as when the coronavirus pandemic broke out, do not faze these companies.
In addition, family companies keep their research and development budgets constant. Their robust balance sheets have sped up the recovery post-pandemic and are also a competitive advantage in the current environment of high interest rates. These days it makes sense to allocate assets to a mix of dividend-based instruments, corporate gems in niche markets as well as family companies that take a long-term view. This approach offers investors attractive dividends and opportunities to make a return even in times of higher inflation and rising interest rates.
¹ Source: Bloomberg / As at: 22 February 2023
² Source: https://www.janushenderson.com/en-gb/adviser/insights/global-dividend-index/
³ Source: Bloomberg