Can dividend stocks help protect your portfolio?
Morgan Stanley Research11/17/22
Summary: Dividends, particularly those that may grow year over year, can help contribute to long-term portfolio returns in a turbulent market.
Market turmoil, rising recession fears and increasing concerns about the global economy’s growth outlook have investors searching for ways to defend their portfolios and find pockets of upside. Investors with long time horizons and relatively low appetites for risk may want to consider dividend-paying stocks, which offer companies’ shareholders regular payments as a share of profits. With the right mix of stocks, dividends can provide for potential cumulative growth as the earnings can be reinvested back into the portfolio or be used to buy additional dividend-paying shares—a tried and true investing tactic that becomes even more favorable amid economic uncertainty.
But not all dividends are created equal. Simply reaching for the highest-yielding dividend stock often comes with greater risk. Instead, investors should focus on finding consistent companies with proven track records of growing their dividends year over year.
The investing backdrop of the past year, driven by macro-economic conditions and combined with the rising risk of recession, have fueled outperformance for many dividend-paying stocks.
Sectors poised for dividend growth
Which sectors might provide attractive yields and dividend growth against the current economic backdrop? Morgan Stanley analysts note the following sectors:
Stocks yielding high dividends outperformed the broader market sharply in 2021 and 2022, in part due to energy stocks, as the rising price of oil drove up energy companies’ cash holdings. The sector became more disciplined after the 2020 oil price collapse, shifting away from years of outspending cash flows and focusing instead on shareholder returns through dividends and buybacks. While lower oil prices could pressure cash flow, some companies in the sector have set base dividend payouts that could be fully covered even if oil falls from approximately $88 per barrel in early November to $40 per barrel.
Dividends in this sector have a stable growth outlook, driven by steady demand and high margins, as well as strong cash flow to pay debts and to make regular payouts to shareholders. On average, companies in the sector offer a 2.8% dividend yield, and Morgan Stanley’s forecast for earnings per share (EPS) growth in the mid- to high single digits supports the outlook for dividend growth. In particular, companies are likely to see strong, sustained sales in snacks, healthy categories and emerging markets.
Beverages and household products
High commodity costs have been a drag on companies that produce beverages as well as those that make cleaning and personal care products. But predictable and stable demand for these everyday items should continue to generate cash and support earnings growth, so these companies could continue their multi-decade trend of raising dividends over consecutive years.
Regulated electric and gas utilities have stable businesses, with limited major risks that would put ongoing pressure on their ability to pay a consistent and growing dividend, even as these companies incur significant expenses to build facilities for generating, storing and distributing electricity or gas. And though regulation and natural disasters, such as wildfires, remain a high risk, utilities companies have generally healthy balance sheets and can issue low-cost debt as needed. As a result, analysts expect dividend growth of 6% annually through 2024.
During recessions, the financial sector can experience increased pressure on earnings as borrowers facing hardship might be unable to make required payments. Even if credit losses rise, however, banks could increase their dividends by up to 36% year over year in 2023, with median growth of 8%, assuming the unemployment rate, a key indicator of credit risk, is at 4%. Should unemployment rise to 6%, dividends could hold flat, though investors will want to note the payout ratio, which is the proportion of earnings paid out in dividends; a growing payout ratio can be a sign the dividend isn’t sustainable.
Balancing risk and return
Dividends can be especially important for long-term investors, and high-dividend stocks tend to perform best when inflation is above normal but starting to fall, as it is now. In addition, their stability and income make them more attractive as economic conditions remain murky. But some of the highest-yielding dividend stocks carry the greatest risks, so investors need to weigh not just dividend growth, but also debt load, the value of the underlying stock and company earnings when considering their dividend-investing objectives.
“High dividend growth is an attractive income feature and paying a dividend is generally taken as a sign of earnings stability from the underlying company,” says Lentini. “But investors should keep in mind that dividend growth means that a company is paying cash to shareholders instead of reinvesting in the business.”
More specifically, the most important factors to consider are the stability of dividend growth; the value of the stock and its relative discount to the broader market; and a stock’s ability to support a portfolio’s performance and reduce its risk.