The Year in Dividend Stocks

Key Takeaways

• When you’re investing for equity income in the shares of dividend-paying stocks, you’re going to get very different stock, sector, style exposures in the overall market, and that’s going to lead to outperformance in some conditions and underperformance in others.
• From an income perspective, there’s no question that dividends aren’t as attractive relative to bonds and cash as they were before the Federal Reserve’s rate-hike cycle.
• A dividend-growth portfolio is going to tend to look more like the market in terms of its sector exposures, its growth and value characteristics, and measures like price/earnings.

David Harrell: I’m David Harrell with Morningstar Investment Management, and I’m joined once again by Dan Lefkovitz, who is a strategist with Morningstar’s Index team and has a strong interest in and expertise on the U.S. equity market, including dividend stocks.

Dan, thanks for being here.

Dan Lefkovitz: Always great to be with you, David.

Dividend Stock Performance

Harrell: I want to talk a little bit about dividend stocks. And of course, it’s no surprise when dividend stocks perform differently than the broad market. Anytime you have the subset of the stock market, you should expect different performance for any given time period. But we’ve seen some really dramatic differences over the past couple of years. In 2022, for example, dividend payers were up about 20 percentage points over the broad market, depending on the index that you used for comparison. This year, we’ve really reversed the situation. The broad equity market is up around 20% on a total-return basis year to date. And most dividend indexes have had very modest returns or even modest losses. So, what’s driving these differences that we’re seeing in relative returns?

Lefkovitz: I think this deviation point that you mentioned is really critical. When you’re investing for equity income in the shares of dividend-paying stocks, you’re going to get very different stock, sector, style exposures in the overall market, and that’s going to lead to outperformance in some conditions and underperformance in others. We put out some research recently looking at this reversal of fortune that you mentioned, and we pinpointed four Bs to help explain this big swing, the flip-flop in dividend performance relative to the market. So, the four Bs were bots, banks, barrels, and bio. To go through them briefly, bots refer to artificial intelligence, which has been by far the biggest driver of equity market returns this year, the dominant theme—stocks like Nvidia NVDA and Microsoft MSFT and Meta META, Alphabet GOOGL, some of the biggest gainers in 2023.

Harrell: Sort of plays into that whole “Magnificent Seven” that we saw earlier this year.

Lefkovitz: Exactly. Not exactly a dividend-rich section of the market. Some of them don’t pay dividends at all. Last year was very different. Tech led the market down. So, that’s disadvantaged to dividend payers or dividend indexes, dividend portfolios this year but was an advantage last year.

Banks. we obviously saw some bank failures earlier this year. Banks tend to be a dividend-rich section of the market. Some constituents of our Dividend Yield Focus Index, like Wells Fargo WFC and Truist TFC, are down this year. And banks held up better last year.

Harrell: Right. So, those regional banks especially. They’re pulling down those.

Lefkovitz: Exactly. Right. And then barrels. So, that refers to the oil and energy sector. This was by far the best-performing section of the equity market last year. This year, energy has not done very well. So, companies like Exxon XOM and Chevron CVX, which are rich in dividends, are down and have dragged down a lot of dividend portfolios, including our Dividend Yield Focus Index.

And then finally, bio – biopharma, healthcare companies like Pfizer PFE, like AbbVie ABBV, have lagged this year for a number of reasons. Healthcare last year did very well. It was perceived as a defensive sector and held up well when the equity market was down.

Harrell: So, really just the dividend payers as a group are not performing as well as the rest of the market or these segments of the market.

Lefkovitz: Our Dividend Yield Focus Index, which I’ve cited, it was actually in positive territory last year, even as the overall U.S. equity market was down. This year, it is badly behind.

Higher Interest Rates and Dividend Stocks

Harrell: Now, interest rates. So, the Fed has paused rate increases for now, but some investors are already expecting cuts in 2024. Because of these higher interest rates, investors looking for income certainly have more options than they did, say, a year ago or so. So, how is that affecting the market right now, at least for dividend stocks?

Lefkovitz: I think there’s no question that from an income perspective, dividends aren’t as attractive relative to bonds and cash as they were before this very dramatic Fed rate-hike cycle. The yield on our Core Bond Index is almost 6%, which is well above the level that you’re getting from a dividend portfolio, dividend indexes typically. There’s also the aspect of debt servicing. So, when interest rates go up, companies that are reliant on borrowing to finance their operations are going to be disadvantaged. So, this higher-for-longer could be affecting them there.

I’m a little skeptical of this as an explanatory variable. We’ve done some empirical research, and we’ve talked about this before, looking at the relationship between interest rates and the relative performance of dividend payers. It’s kind of a mixed picture. It’s not as clear-cut as interest rates go up, dividend payers go down. There’s been plenty of times when dividend payers have done well, even among higher interest rates. There are always a lot of different variables interacting, a lot of different factors at play driving asset prices.

Harrell: You did speak, though, about debt servicing. Some companies that do have a fair amount of debt and are dividend payers, do you think that the higher interest rates they’re paying now on that debt might affect their ability to, say, increase their dividends going forward?

Lefkovitz: This could be a factor in the utilities sector. If utilities started with B, I would have mentioned them earlier, but utilities is another area that has really lagged, and it’s a dividend-rich section of the market. It’s possible that both the income perspective as well as the higher borrowing costs are affecting utilities. There are some other factors there, like regulation. But our equity research team has noted that the utilities sector is coming off many years of pretty solid gains, and valuations looked kind of stretched coming into the year. So, it could be a valuation story as well. On a forward-looking basis, our equity analysts are seeing a lot of opportunity and upside in the utilities space. Companies like NextEra NEE and American Electric Power AEP and Duke Energy DUK are all trading at attractive valuations.

Harrell: That’s definitely what I wanted to ask you about because I think just on a performance basis, the U.S. utilities sector is the worst performing year to date. It’s around 9% or so. So, we’re starting to see maybe with prices down, the valuations are looking better on some of those utilities.

Lefkovitz: Yeah.

High-Yield Strategy and Dividend-Growth Strategy

Harrell: When we look at dividend payers as a group, it’s not a homogenous group of stocks. And people who are investing in dividend stocks, you can almost divide them into folks who are looking for the highest current yield for the current income and then those pursuing maybe a dividend-growth strategy, where they’re seeking companies that have a strong record of dividend increases, but they might not have high yields currently. Now, when you divide the dividend payers along those lines, what are you seeing in terms of trends of valuation and performance?

Lefkovitz: This is a really important point. Dividend growth is really a different animal to high-dividend investing. And dividend growth, which is a signal of a company’s competitive position being strong and its fortunes improving, a dividend-growth portfolio is going to tend to look more like the market in terms of its sector exposures, in terms of its growth and value characteristics, measures like price to earnings. It will still have a value tilt to it, but it will be more core than a high-dividend portfolio. So, our Dividend Growth Index, for example, has Apple AAPL and Microsoft in it, which the High Dividend Index that I mentioned earlier, does not. And behavior, as you’d expect, is going to be more like the market than a high-dividend portfolio. So, our Dividend Growth Index, it has risen this year, but not as much as the market. Last year, it declined, but not nearly as much as the market.

Harrell: So, some of those stocks like the Apples and Microsofts, which do pay a dividend, but it’s a fairly low yield.

Lefkovitz: That’s right.

U.S. Equity Market 2024 Outlook

Harrell: And looking at the overall U.S. equity market right now, what are you thinking for 2024 based on current valuation?

Lefkovitz: Our equity research team is definitely seeing a lot of upside, a lot of attractive valuations in sectors that are rich in dividends. So, whether it’s energy or utilities, healthcare, consumer defensives, they see those sectors in aggregate as undervalued and having upside. On the flip side, technology, which has had a really nice run this year and is certainly more dividend-rich than it used to be, but typically an underweight exposure for dividend portfolios and certainly our dividend indexes, technology is a sector where our analysts are seeing overvaluation. It’s had a really strong run this year. It’s nearly 30% of the U.S. equity market currently. Now valuation is never a timing signal. It can take a long time for price and fair value to converge, but it’s certainly something to keep an eye on.

Harrell: Dan, that’s great. Thanks for sharing your insight. Always good to have you here.

Lefkovitz: Thanks so much, David.

Harrell: Thanks. I’m David Harrell from Morningstar Investment Management. Thanks for watching.

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Watch “Are Small-Cap Stocks Worth Investing In?” for more from Dan Lefkovitz.