Equity Income — 2 (of 5) Key Considerations for Investors
Here I’ll cover the first 2 of the 5 key considerations for equity income investors, and 3 more in Part 2.
At a time when demand for income generating assets is at an all-time high, the yields on income generating assets are at, or near, all-time lows. While the headlines often speak to the number of Baby Boomers entering retirement, the more important statistic is actually the amount of wealth entering retirement. According to the U.S. Census Bureau, of the 125 million households in the U.S., 32% fall between the ages of 55 and 70. That group also represents a disproportionate 57% of median household net worth.1 Assuming these retirees and near-retirees started saving around age 30, that would place the beginning of their “investment memory” somewhere between 1976 and 1991 and continuing to the present. That entire span was encapsulated by arguably the greatest bond bull market ever, and some of the most robust equity returns in history.
As this cache of wealth is in or approaches the distribution phase of the investment lifecycle, the thirst for income generating assets will be unquenchable. Most retirement models are predicated on a 4% annual withdrawal from retirement assets. In a world of 2-ish% equity and bond yields, such a large annual withdrawal seems optimistic and susceptible to substantial sequence-of-return risk.
Though this cohort lived through a golden age of financial asset return, they have also experienced the most dramatic bear markets since the Great Depression. The tech bubble in the early 2000s and financial crisis of the late 2000s marks the first time two greater-than 40% downturns occurred in a ten year span, again since the Great Depression. An adaptation of the old adage, twice bitten thrice shy, may appropriately describe many investors.
McKinsey captured the outcome of this phenomenon in a recent report, which suggested that investors are laser focused on: (1) protecting principal, (2) hedging against severe downside risks, (3) minimizing volatility, and (4) generating income.2 While the active management industry has been toiling to identify yet uncovered sources of alpha, investors seem to just want a reliable combination of principal protection and income generation at a reasonable fee. Investor sentiment has shifted, for now, from performance to solutions-focused objectives.
ETF asset flows confirm the popularity of at least two of these preferences. The most popular ETF categories, outside of the broad shift to market cap-weighted passive vehicles, have been low volatility and dividend-focused.
Asset Flows by Method ($ bil)
While equity income could never be a substitute for the principal stability of fixed income, it does offer compelling long-term income generating potential. With equity yields comparable to most 10-year government bonds, they have become an increasingly popular component of retirees’ portfolios.
5 Considerations for Seeking Dividend Income
Dividend investing requires great care, particularly in the current environment. The combination of poor recent performance, elevated valuations, and uncertainty as to the path of interest rates are enough to perplex most investors. In speaking with advisors and clients across the country, I have identified five key considerations for equity income investors. I’ll cover 2 of them here, and the remaining 3 in the sequel to this post. I also offer suggestions for equity income investors to ponder.
1. Dividends performed terribly in the years preceding 2016 — that’s a good thing.
We have just emerged from a period when stocks with strong dividend yield have struggled. As an investment theme, dividend yield found itself at the epicenter of three major events that conspired to drive lackluster performance — declining oil, a rising U.S. dollar, and U.S. outperformance.3 The late-2014 crash in the price of oil in took its toll on Energy firms. As oil recovered from its 2008 lows, profitability at large oil and gas exploration and production firms increased. They expanded their dividend programs and dividend investors found solace in the strong dividend yields offered. As oil declined in 2014, these previous darlings of the dividend space sold off. Because oil and the U.S. dollar tend to be inversely related, the U.S. dollar strengthened during this period. For global dividend investors, the strengthening of the U.S. dollar served as an additional headwind to performance. Further compounding the performance issues for globally-oriented investors, persistent geopolitical concerns have resulted in dramatic underperformance of developed international and emerging markets. As of October month end, the S&P 500 was beating its developed and emerging counterparts by around 10% annualized over the trailing three years.
Below is a snapshot of calendar year excess returns for stocks with strong dividend yield and dividend growth. Whether you favored dividend yield or dividend growth from 2012–2015, domestically or abroad, chances are high that performance has been challenged.
Dividend Yield vs. Dividend Growth
Excess Return vs. Large Stocks (2012–2015)
It would be easy to cast dividend payers aside for that reason, but know that historically it is very common for investment factors to come in and out of favor. So far in 2016, dividend yield has experienced a solid recovery. The chart below shows the rolling 5-year excess performance of stocks in the top quintile of dividend yield back to the 1970s. Notice that periods of underperformance are followed by prolonged and/or significant periods of outperformance.
Top Quintile Global Dividend Yield
Rolling 5-year Excess Return vs. Large Stocks
Though a poor timing mechanism, mean reversion is a very real phenomenon. Investors willing to bet against the trend tend to get rewarded over time. They are by definition, contrarian. If history serves as a guide, it is possible dividend yield may continue to be in favor for years to come.
2. Certain dividend payers historically buck the rising rate performance headwind.
The fear of rising interest rates has been particularly alarming for some investors, most notably back in 2015 as the Fed wavered on the timing of rate hikes. For the most part, the pain inflicted there was psychosomatic. The Fed had actually started tightening as far back as 2013 with the announcement of “taper” (when the Fed started reducing its monthly bond purchases). With some positive recent economic data, and what is perceived as a pro-business election outcome, rates have again moved higher in anticipation of a hike. The concern now is that interest rate sensitive assets — Utilities in particular — will get torpedoed when the Fed starts raising in earnest.
When looking at the 12 environments where the 10-year U.S. Treasury rose by 1.0% or greater over a 12-month period, I found evidence to support that suspicion. In comparing the performance of the Utilities sector to an equal-weighted universe of large capitalization stocks, it underperformed in 10 of the 12 environments and had an average underperformance of -8.5% on an annualized basis. Real Estate (REITs) underperform, but robust data only covers three of the rising rate environments so it’s challenging to draw inference. Beyond REITs, Financials are the second weakest-performing, with banks underperforming by 2.9% on average across the 12 periods. On the positive side, Energy and Info Tech did exceptionally well, outperforming by 6.1% and 7.4% on average, respectively. Energy outperformed in eight of the 12 environments while Info Tech outperformed in nine. It’s important to note that these are averages across some very unique periods in market history — from the inflationary death spiral of the 1970s to the tech bubble of the late 1990s.
Highest/Lowest-Ranking Sectors in 12 Rising Rate Environments
Average Excess Return vs. Large Stocks (1970-Present)
As we move into a rising interest rate cycle, it may be prudent to consider shying away from the sectors (Utilities and REITs) that have done poorly in those environments. However, as evidenced by the performance of yield after the December 2015 rate hike, don’t underestimate the total return potential of the dividend theme. Sometimes markets become too pessimistic, which breeds opportunity — as was the case late last year.
Go to Part 2.
Go to the Webinar (Replay).
- Calculated based on the number of households by age cohort and their share of the weighted median net worth for households across age cohorts.
- See “The $64 Trillion Question: Convergence in Asset Management” (Pooneh Baghai, Onur Erzan, and Ju-Hon Kwek; Feb-2015 (http://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/the-64-trillion-question)
- All references to excess out/underperformance in this post are in relation to an equal-weighted universe of “large” stocks that trade on U.S. exchanges and have a market capitalization greater than the overall universe average.