Where to Find Dividends Now

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Tom Lauricella: I'm Tom Lauricella from Morningstar. And today I'm joined by Alec Lucas, and we're going to discuss the landscape for dividend investing. Alec, thanks for joining us today.

Alec Lucas: Thanks for having me.

Lauricella: So there's been a lot going on when it comes to dividend investing, investing for yield in general. We've had a big drop in interest rates. We've had a big hit to the economy, which flows through to a company's abilities to pay dividends. Why don't you give us an overview of what the landscape looks like for an investor trying to invest for yield?

Lucas: Income has become hard to come by. That was true before the coronavirus closures happened here in early 2020, and it's especially true after. So to give context, the 10-year Treasury's yield, which had been above 3% briefly in years past, since April, it's been around 60 basis points to about 80 basis points or so. So, around all-time lows, and it's not going to beat the historic inflation rate of about 2.2%. Corporate bonds could edge the cost of living, the Bloomberg Barclays U.S. Corporate Bond Index had a 2.7% yield to maturity as of April 30.

But the problem with bonds, of course, is that their prices could fall if yields rise. And so there's also some default risk with that, too. So dividend-paying stocks on first blush don't seem so attractive because there've been a number of dividend cuts--by my count from late February through mid-May or so, 240 companies in the U.S., at least 240 companies have cut their dividends, or canceled buyback plans, or suspended their dividends. At least one of those things.

But if you look at the comparison between the projected one-year dividend yield on the S&P 500 versus a 10-year Treasury, stocks look historically attractive relative to the yield on bonds right now. So, if you can invest smartly in dividend-paying stocks, that is a way forward. And of course, with dividend-paying stocks, you have the benefit and potential for price appreciation, as well as the dividend raising, the payout increasing, over time. And of course you are taking on additional volatility when you invest in equities versus bonds, but if that's done well, it can be something that's additive to a portfolio.

Lauricella: So investors looking for yield right now, it appears that stocks offer the potential for better returns. But of course, there's different ways to come about that. And you mentioned that dividend growth is one aspect of this. But for some investors they may just simply be out there looking for just whatever the highest-yielding stocks there are. Given this environment, what probably makes more sense in terms of investing for dividend growth, or investing for simply for yield?

Lucas: I think if you're going to pursue income through equities, you have to have in mind two categories of companies--or strategies, rather--that you invest in. One is high-dividend-yield strategies. They tend to invest in mature companies that are very cash-generative and pay out a large portion of their earnings to shareholders, and that results in a high yield. So we're thinking in this environment, 3% would be pretty substantial, even 4%, but you want to be careful that you don't invest in companies that are offering such an attractive deal that it signals that the company's prospects for growth might be distressed. So if you see something in the neighborhood of 7% or higher, that's an indication to investors that that yield might soon disappear.

In contrast to high-dividend-yield strategies are dividend-growth strategies. And in this case, the companies tend to be a bit younger. They tend to have more growth, and they're paying out a lower percentage of their earnings, and so the yield itself is smaller. So think around 1.0%, 1.5% or so, but they're growing their payout steadily. And of course if the share price is increasing then the yield may actually go down even as the payout goes up. And that's of course a good problem for investors to have. Those kinds of companies have shown more resilience, typically, than high-dividend-yielding stocks, and they've been less prone to cut their dividends. And that's certainly the case in this recent coronavirus environment.

Lauricella: And you mentioned some of the data that you've looked at in terms of the number of dividend cuts that we've seen. Can you go into a little more detail in terms of where we've seen those dividend cuts? What types of companies have they tended to be on? How broad-based has this been? It's a big number, but where is it concentrated?

Lucas: Dividend cuts have been fairly widespread, but that doesn't mean that certain parts of the market haven't been hurt more than others. But to speak to the widespread nature of dividend cuts, there have been at least 240 U.S. firms that have cut their dividends, suspended their dividend, and/or canceled buyback plans. And that's 68 out of 142 Morningstar industries have been affected.

But the industries that have been most affected tend to fall within the energy space. So oil, gas, and exploration companies lead the way, followed by oil and gas midstream companies. That's probably not surprising given the investors who've been following the energy space, given that there's been a challenge, both from demand as well as an oversupply. So that's put a special pressure on energy, which was challenged even entering the year.

Real estate investment trusts have cut their dividends. Obviously with questions about companies leasing office space, and so forth, that's been a headwind for them, and a major one, and led to a lot of dividend cuts. Some noteworthy places where you've seen dividend cuts that you perhaps you might not expect: Regional banks have cut their dividends. Asset managers have tended to cut their dividends, smaller ones, and obviously airlines and restaurants and retail--you've seen dividend cuts there as well.

If you look the whole universe of companies that have cut their dividends, certain themes emerge. One of them is that they tend to be smaller companies. So out of those 240 companies that cut their dividends, the median market cap was $1.1 billion. So that's a small-cap company for the most part. And of course you have to take in the fact that their market caps have shrunk, obviously with the market turmoil, and the cut of the dividend that would have naturally shrunk the market cap, but even taking that into account, these are smaller companies.

Bigger companies, though, haven't been entirely unaffected. There's 220 stocks in Morningstar's US Large Cap index, and 21 of those companies cut or suspended their dividend and/or canceled buyback plans. And so some prominent companies that are in that index that you've heard about in the news: Boeing would be one, Schlumberger, Occidental Petroleum, Southern Copper, but even a stalwart like McDonald's or 3M have canceled buyback plans. So companies obviously are being conservative. And this is in contrast to what we've seen in the market. The market has had a pretty significant rebound since its March 23 low. In fact, April, the rally in April, depending on the index you look at, was one of the strongest we've had in a long time. And yet April was also a month in which we saw an acceleration of dividend cuts.

I think investors have to be cautious when going to equities for yield, and they have to play it smartly. And again, I would suggest that the way to do that is to keep in mind the difference between high-dividend-yielding companies, and you don't want a dividend that is so high that it's prone to being cut, because the market is signaling that. And again, that's in a yield of 7% or more--you'd have to be especially cautious on that. And a small yield might be unattractive in the present, but that's the kind of thing where the payout might grow given the company.

Lauricella: So what are we seeing in terms of how mutual fund managers that oversee dividend strategies, how are they faring? How are they navigating this? What are we seeing from, for example, some of the Morningstar Medalist dividend funds?

Lucas: With all the dividend cuts, you would expect that income-oriented funds have been hit the hardest. And certainly we've seen some strategies hold companies that have cut their dividends. So Royal Dutch Shell is a holding in a number of funds, that's a company that cut its dividend, but in general, active managers who have income-oriented strategies are very used to thinking about potential dividend cuts and trying to steer away from companies where they're worried about that. So we've seen an impact but not perhaps as dramatic as you would expect. An example would be American Funds Income Fund of America, which strives for an above-average dividend payout and invests in stocks but also bonds as well. Its March 2020 portfolio, just 2.3% of its assets were in companies that cut their dividends. And about half of the stocks in that portfolio had already cut their dividends. And another half would go on to do so.

Where we have seen strategies most affected by dividend cuts are deep-value strategies. So LSV, which has a small-cap value strategy, as well as subadvises a mid-cap value strategy--they've held double-digit stakes in companies that have cut their dividends, but these kinds of companies are, again, smaller. So we're thinking about small-cap REITs, the kinds of things that a lot of the largest active funds just aren't investing in, but they've held because they tend to have a contrarian streak.

And I would clarify that just because of manager holds a company that cut its dividend doesn't actually automatically trigger a sale. A good example of this is T. Rowe Price Equity Income. Its manager, John Linehan, takes into account a total yield when he makes investments, so dividend plus share buybacks, and he's reticent about selling a stock if he sees a path for recovery. And so a good example of that is if you compare his year-end 2019 portfolio with his March 2020 portfolio. He had airline exposure at the end of 2019 but continued to have it in March of 2020. He did sell a position in Southwest, as well as Delta, but Alaska Air, he actually added to Alaska Air Group, his position in Alaska Air Group. Modestly so, but added exposure amid the cut.

Lauricella: All right, great. That's a lot of fantastic information. Alec, thank you very much for being here today.

Lucas: Thanks for having me.