Markets & Research
When market downturns have struck, dividend-paying stocks have usually been a source of relative comfort. Their appeal in troubled times is simple: Management’s commitment to regular payouts signals an expectation of stable cash flow, even amid a recession, and dividends can partially cushion the share price declines of a general market selloff.
Of course, there’s always an exception to a rule — and for dividend payers this year is that exception. The dividend payers in the S&P 500 fared worse than the index as a whole in February and March as COVID-19 hammered markets. The disappointing results stand in stark contrast to the comparative strength of many nondividend securities, especially those in the technology sector. The unexpected weakness of income-producing stocks has raised questions about how truly defensive dividend-paying companies are.
However, there are signs that the group’s poor showing stems from the unique circumstances of the coronavirus-induced selloff rather than from an inherent flaw in high-quality dividend payers.
Normally, dividend payers are defensive. Though they often trail their benchmarks during bull markets, they have tended to provide both income and downside protection during recessions. But during the market pullback in February and March, the top 20% of dividend-paying equities by yield in the S&P 500 had markedly lower returns than the rest of the index — an unusual result given these securities’ historical performance.
“Before this year’s COVID-19 fallout, dividend-focused portfolios matched or beat the broader market during the past nine downturns,” says Greg Singer, investment director at Capital Group Private Client Services.
Recessions typically occur when various economic imbalances accumulate and become unsustainable, Singer explains. The result is a broad decline in market value as liquidity dries up, consumers spend less and businesses resist taking chances.
“This time, we voluntarily shut down an economy for health reasons,” he says. “It’s a totally different situation, and we have to expect the impact on corporate profitability and the markets to be different.”
Another unique effect was that regulators in Europe required recipients of government aid packages and companies that were reducing employment to suspend or cut dividends. Many of the world’s strongest dividend payers are stationed there, so the rules weighed on income-focused portfolios.
Energy companies, another group that has traditionally paid reliable dividends, were hit especially hard. Gasoline demand dried up because people used cars and airplanes less amid lockdowns, and prices fell further when Russia and Saudi Arabia flooded the market during a brief price war. As a result, some oil and gas companies slashed their payouts for the first time since World War II.
“There’s been a real dent in some of the traditionally safe investments,” Singer says. “But that damage is largely due to unique circumstances of the pandemic.”
Although it’s true that the top 20% of dividend payers offered little protection during the most recent downturn, that might not be the best way to examine the market, says Aline Avzaradel, a Capital Group equity analyst. She divvied up that highest-yielding group and found a marked difference between the top and bottom halves.
“There’s a real bifurcation in the market,” she says. “The worst performers are in the highest yielding decile, or the top 10%. But the second-highest decile — the top 80% to 90% by yield — has offered many of the traditional benefits of dividend payers.”
The highest-yielding segment is more likely to contain companies with weak balance sheets, stretched payouts and poor fundamentals; such companies sometimes turn to high dividends to attract shareholders or supplement weak valuations. While those yields can be attractive, those companies are the least likely to be able to pay out sustainable dividends, Avzaradel says.
By contrast, the companies in the second-highest decile are often well managed and dedicated to returning profits to shareholders. As a group, they’ve historically offered downside protection alongside results far closer to the S&P 500’s.
“I find this really exciting,” Avzaradel says. “It means that we absolutely can find high-yielding stocks that have done well over time.”
Keeping the focus on quality high-yielding companies will be critical in the coming months, Singer says.
“We might not be clear of the pandemic for quite some time,” he cautions. “Looking to the other side of this virus — it could be bumpy between here and there. Defensive dividend payers likely will have lower debt levels and a positive cash flow even if economic activity remains at below-normal levels.”