“History provides a crucial insight regarding market crises: they are inevitable, painful and ultimately surmountable.” — Shelby M.C. Davis
With the seeds planted in 2022 (geopolitical tensions, high interest rates, inflationary pressures, and slowing global economic growth) seeming to take root in 2023, the likelihood of heightened volatility is becoming more probable. While many investors are at a loss for what to do under these circumstances, there are still profitable moves to be made in uncertain times.
A core part of our strategy—dividends—may be that very move. But not all dividends are created equal; here, we pay attention not only to dividend growth itself but also to dividend growth potential.
The S&P 500: Rally or Risky?
The recent rally in the S&P 500 looks like something to be celebrated at first glance, but upon closer inspection, there may be reason for concern. Five companies (Apple, Microsoft, Amazon, NVIDIA, and Alphabet) account for more than 20% of the index’s total value as of May 12, 2023. Even more worrying is that, according to S&P Dow Jones Indices, 10 companies were responsible for 90% of the gains seen in Q1.
A concentration this narrow, by both number and sector, is not ideal for diversified portfolios. A comparable scenario occurred in December 2021, with a similar list of companies (replacing Amazon with Meta Platforms) driving the market. With the benefit of hindsight, they have not reached peaks in that cycle since.
This isn’t to say these equities are bound to tumble, but rather to highlight the associated risks. To outperform the index in these conditions, an investor would essentially need to overconcentrate their portfolio into five companies. The downside to such a “gamble“ is immense and something we cannot do for our clients in good faith.
In a climate such as this one, focusing on fundamentals and dividends with the potential for growth can help you bide your time and grow your wealth.
The Benefits of Dividend Growth Strategies
Many wrongfully view dividend strategies exclusively as a conservative approach. But contrary to that belief, they can (and, in our opinion, often do) lead to significant gains in a market that is anything but forgiving.
With the capability to mitigate losses in the short term, increase distributions in the medium term, and appreciate in the long term, dividend growers are once again showing their value as strategic assets to support your investment portfolio.
We are keen on dividends to hedge our clients’ portfolios against market risks. While equities may suffer under these economic circumstances, data from BMO suggests that dividend growers can produce their best relative returns when inflation is above 4%, a range we already find ourselves in. In fact, on May 16, 2023, Statistics Canada announced that we had seen “the first acceleration in headline consumer inflation since June 2022.”
Inflation and rising interest rates can place downward pressure on companies with high dividend yields for interconnected reasons. As operational costs increase and revenues shrink, there may be less opportunity for increases going forward. Going a step further; if a dividend is unable to keep pace with inflation, it is losing relative value. Companies with a free cash flow yield greater than the dividend yield (typical of dividends with a history of growing) are less likely to suffer from these issues.
Dividend Screening Methods
Many screening methodologies typically chase high yields. While this is certainly not a bad idea, it often disregards dividend growth strategies. By placing too much focus on companies with yields above 3%, significant opportunities can be left behind for companies with more moderate yields.
Our preferred screening methodology considers several important variables to arrive at a more holistic understanding, such as cash flow growth potential, well-positioned balance sheets, healthy payout ratios, and proven track records of increasing dividends to shareholders. This final measure translates to a level of reliability that typically rewards investors over longer timeframes. Companies with a history of growing their dividends, for the most part, do so during the highs and lows of a cycle. Despite ballooning inflation or climbing interest rates, these businesses are resilient and have strong management teams.
A healthy mix of the two, growth potential and existing yield, can be the ideal position to take: high yields can dampen losses while you identify up-and-coming stars with strong fundamentals. In fact, certain dividend growth potential screens have historically outperformed the TSX by +10% while the CBOE Volatility Index (a useful barometer of equity market volatility) is on the rise and typically performs even better when equity markets encounter corrections.
With the level of uncertainty surrounding current and future economic conditions, it’s becoming increasingly important to manage risk appropriately. For this reason, you can benefit from existing dividend yields while also using growth strategies for what they are: an opportunity to grow your wealth while creating a reliable, appreciating stream of income.
As the S&P 500 walks the tightrope in the face of market volatility and various pressures, it would be wise to prepare a safety net to soften the landing if the curtain falls early. Diversified portfolios likely lagged the index recently, but investing is a matter of endurance and strategy. Dividend yields may provide you with the means to endure right now, but the dividend growth opportunities we’ve identified can set you up for the future.
In a downward market where capital appreciation may be staggered, dividend strategies can help mitigate losses; in fact, ”69% of the total return of the S&P 500 [since 1960] can be attributed to reinvested dividends and the power of compounding.” If that’s something you’d like to take part in, it’s thankfully something our Family Wealth Advisors specialize in.