Dividend Stock Deep Dive: Midyear 2022 Picks

Rising interest rates, hot inflation, and economic uncertainty have led to a stock and bond market selloff in 2022. In this conversation, David Sekera talks about how dividend stocks have held up so far this year and what dividend stock investors might expect from here.

Sekera discusses:

• Will rising interest rates and inflation sink dividend stocks?
• What a recession may mean for stocks.
• Six dividend stock picks.

David Harrell: Hi, I'm David Harrell of Morningstar Investment Management, and I'm here with Dave Sekera who is the chief U.S. market strategist for Morningstar.

Dave, great to have you here.

David Sekera: Well, thank you, David. Good to be here.

Harrell: So, we spoke back in January, the last time we spoke, and at the time you noted that the U.S. equity market was slightly overvalued. And so, absolutely nothing has changed since then, right?

Sekera: Yeah, well, you know, it's certainly been a really tough quarter in the second quarter here. And so, yeah, we did definitely start off the year in what we considered to be overvalued territory. But at this point, I think the market has taken enough of a beating that we're seeing a lot of value out there today. And in fact, based on those 700 stocks our equity analyst team covers that trade in the U.S., we think the market is trading at about a 17% discount to our fair value.

Now, to put that in a little bit of historical context, when I look over the past decade, actually going back to the end of 2010, there's only ever been a couple of other instances where we've seen the broad market actually trade at that great of a discount. So, for example, during the emergence of the pandemic in March 2020, we saw the big selloff then, the markets got down to very low levels of valuation. But then, before that, we looked at Dec. 18. So, if you remember, back then, the Fed had already been tightening monetary policy for about a year at that point in time. A big growth scare at the end of the year. We saw a big selloff in December before the markets came back in the beginning of 2019. And then, you have to go all the way back to the end of 2011. And if you remember, back in 2011, that's when we had the Greek debt crisis. A lot of investors were concerned that you'd have the sovereign debt crisis then spread into Portugal, Spain, Italy, and then those kinds of sovereign defaults. Back then, people were concerned would then end up tarnishing the entire EU banking system.

Read more: After Tough Second Quarter, U.S. Stocks Look Cheap

How Dividend Stocks Have Done in 2022

Harrell: So, one thing, if you look at the performance of dividend stocks, at least the dividend stock indexes, you're generally seeing better relative year-to-date performance than the overall U.S. market, correct?

Sekera: Yeah, that's absolutely correct. So, for example, if we look at the Morningstar US High Dividend Yield Index, we see that's only dropped about half of the broad market year to date.

Harrell: And why do you think that is?

Sekera: When we break that up and look at its individual components, what we will notice is that the dividend payers are more often than not going to be a core, or blend stocks, or value stocks as opposed to growth stocks. And so, when you look at performance year to date for the broad market, growth stocks have really taken the brunt of the selloff. Large-cap growth stocks this year have sold off over 30% year to date, whereas for example, value stocks have only sold off about 7%. Then, I also take a look at those sectors that usually have the high-dividend-paying stocks, and again, those are usually going to be more defensive type of sectors as opposed to cyclical. And again, when we break down that market performance, the defensive stocks this year have held up relatively well compared to those cyclical stocks, which really have taken the selloff.

Will Rising Interest Rates and Inflation Sink Dividend Stocks?

Harrell: Earlier this year, you talked about some of the headwinds that the U.S. equity market was facing, and many of those are still in place. I was wondering if you could talk about them, specifically, how they would affect dividend stocks. And maybe we could start with rising interest rates.

Sekera: Of course. So, as you mentioned, at the beginning of the year, we did note that there were going to be four main headwinds that the market was going to need to contend with this year. And I think what we really saw in the second quarter in the market performance was a convergence of all four of those headwinds coming together. We did see interest rates, of course, this year rise across the entire curve. I usually watch the longer end more because that's what I think about when I'm looking at comparing interest rates versus dividend and yield stocks. So, in this case, the 10-year has risen about 140, 150 basis points this year and is maybe trading just below 3% today. And I also think too that the rise in interest rates is now making some investors more interested again in fixed-income securities. Specifically looking at what's going on in the corporate-bond market, for example, the investment-grade market. I think our investment-grade corporate-bond index right now is trading at about 4.5%. And in the high-yield market we're seeing 8% coupons again. So, again, those bonds are starting to look more attractive to some investors versus dividends. We're now just getting to the point, I think, where we're starting to see some investors that were using dividend-income stocks really as a substitute for fixed income who might now be starting to switch back and moving back into those higher-yielding fixed-income securities.

Harrell: And obviously, another one of the headwinds the market was facing is high inflation rates and maybe if you tell us a little bit of how that is affecting dividend payers right now or will affect them going forward?

Sekera: Yeah, inflation has actually been running hotter, I think, than what we necessarily expected, even when we were coming into the beginning of the year and noted that as being one of the headwinds. And I know our U.S. economics team has increased our inflation expectations for this year. Now, having said that, I would note, we do still expect the inflation will begin to moderate in the second half of this year, and our U.S. economics team is looking for inflation to go to just below 2% next year. So, again, we still expect inflation to come down. And when I'm thinking about that, it still tells me I should be looking for those high-quality stocks, those stocks that have sold off too much, whereas people I think are looking at the stocks and some of these stocks with wide and narrow economic moats and just indiscriminately been selling those off in the marketplace just because with the market down as much as it had been, we're seeing some portfolio managers who got to the point where they started having to sell what they could as opposed to what they wanted to. And that to me now just brings up lots of opportunities in those high-quality stocks, especially those that have good dividend yields.

What a Recession May Mean for Stocks

Harrell: Terrific. And one more headwind, or maybe not a headwind, but--I hate to use the word--but recession, and do you see the U.S. economy in recession, heading into a recession? And if so, how severe do you think that might be?

Sekera: So, it's always tough to tell. But again, what we did is, we noted at the beginning of the year that we expected the economy to slow down this year, and I would note that it has been slowing probably even more than what our U.S. economics team had originally forecast. Now, having said that, we're most recently projecting a 2% real GDP growth in the U.S. this year. But I think what's more important is not necessarily are we going to enter a recession or not enter a recession. But if we do enter a recession, we expect that it would probably be short and shallow. And so, when I think about what that means for stock valuation in general and looking at where valuations are today, I think that even if we're wrong and there is a near-term recession, there is enough margin of safety in a lot of these stocks today that investors can still go ahead and get invested in those stocks today and not necessarily worry about that much more downside.

6 Dividend Stock Picks

Harrell: And to sort of turn back to dividend stocks in general, you noted earlier that some of the more defensive areas of the market--consumer defensive, healthcare, utilities as well as energy stocks overall--are somewhat fairly valued right now. Now, given that those are generally the sectors where we find some of the better dividend payers, where do you see value right now sort of on a sector basis or even individual company basis for investors who are looking for income stocks?

Sekera: As a sector overall, when you look at those composites, you are absolutely correct that those defensive sectors have held their value better to the downside and maybe not necessarily as many all-in absolute return opportunities as you might see in some of the other sectors where they don't pay a dividend, but they're trading at even lower valuations than what we see in the defensive sectors. Now, having said that, there's plenty of opportunities in all of the different sectors. So, before we came down here, I ran one of our dividend screens by sector.

So, just running off the list here, basic materials, the first one that I would recommend would be taking a look at Eastman Chemical EMN. So, it was actually one of our top picks in our quarterly outlook. It's currently a 5-star-rated stock, has a narrow economic moat. It trades at a 35% discount to our fair value. And what I also like about Eastman Chemical is, I think, it's actually a good way for investors to also to be able to play that long-term structural shift that we see for electric vehicles. So, when you think about specialty chemicals, it requires a lot more chemicals to be able to produce an electric vehicle than it does an internal combustion engine vehicle. And so, therefore, we think that's a good tailwind in the basic-materials sector.

Some of the other sectors that we see a lot of opportunities would be in the communications sector. A lot of the traditional communication names, we think that those are now valued low enough that they're attractive for investors today. So, in the telcos, I would look at both AT&T T and Verizon VZ. Both of them are narrow economic moats. Both are rated 4 stars, trading at somewhat similar discounts to fair value, and both of those are paying over a 5% dividend yield today.

Consumer defensive sector, again, fully valued overall, but certainly always going to be individual names in there that we see differently than what the market is seeing. So, two names there that rarely do you see these names trading at much of a discount to our intrinsic valuation. But opportunities today in both Clorox CLX and Kellogg K. So, both of them pay about a 3.2% dividend yield today. Both are wide-moat-rated stocks. Both are 4 stars at the current levels. So, again, I think those are some interesting opportunities to take a look at as well.

In the industrials sector, 3M MMM, just a high-quality name, wide economic moat, trading at a 4-star rating, trading at a 30% discount to our fair value. Again, I think it's going to be a worthwhile position for investors to take a look at.

Harrell: Well, that's terrific. Thanks for sharing your insight, and I hope we can talk again later this year.

Sekera: Well, thank you. I appreciate it.

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

For more recent insights from David Sekera, watch: Where to Invest Your Money in Q3 2022 9 Cheap Defensive Stocks