As interest rates rise and dividend-paying stocks stumble, opportunities have cropped up in sectors that hold promise for dividend growth ahead.
Many investors favor dividend paying companies for current income and relative defensiveness in periods of market volatility. However, while these companies tend to have strong business models that allow them to return capital to shareholders, they are also affected by macroeconomic factors that can take investors by surprise.
In fact, dividend stocks tend to be sensitive to the interest rate environment, declining in price when interest rates rise. Rising interest rates can encourage investors to pursue more cyclical areas of the market that perform well when the economy is growing. Additionally, higher interest rates provide a more competitive alternative to investors looking for income which reduces the relative attractiveness of dividends. The result is that rising rates can hinder dividend stock returns, even when the overall economy and company fundamentals remain strong.
True to form, this year, rising rates have led to a broad sell-off in many dividend-paying stocks and sectors. However, as a result, we are starting to see solid opportunities for investors to acquire dividend-paying stocks–especially in sectors that exhibit high dividend growth potential.
Take note: Due to simple math, when a stock price falls, the dividend yield rises (you can calculate the dividend yield by dividing the dividend per share by the stock price). That can make these stocks more attractive to investors seeking income. But we don’t recommend investors simply chase the highest dividend yields. We suggest they look for companies that are raising their dividend per share and are likely to keep doing so. That’s an excellent sign of financial health.
In fact, amid recent higher volatility and the rising interest rate environment, stocks with more moderate dividend payout ratios (dividends as a percentage of earnings) have actually outperformed those with the highest dividend payout ratios. We expect this to continue in 2018, underscoring our preference for stocks with dividend-growth potential versus those with the highest absolute yield.
We’ve identified four parts of the market that appear well positioned for dividend growth:
- Financials. Prior to the financial crisis, the financial sector contributed about 30% to the S&P 500 dividend yield. Post-crisis, this fell to about 9% as banks retained more cash to shore up their balance sheets. With capital levels restored, the Federal Reserve is expected to allow banks to return more capital to shareholders once again. In fact, Betsy Graseck, who covers large-cap banks for Morgan Stanley & Co., says banks have some $100 billion in excess capital, which could lead to higher payouts in 2018 versus last year. We believe that these dynamics make the sector attractive from a dividend-growth perspective, particularly as financials offer a buffer against rising interest rates, given that they can make higher profits as rates rise by charging more for loans.
- “Old” technology. While high-growth “new tech” stocks have enjoyed powerful upward momentum until recently, we believe that “old tech,” or value-oriented, tech stocks are ripe for dividend growth. Many of these companies have legacy enterprise hardware assets that provide substantial free cash flow to support investments into faster-growth areas like cloud computing and data analytics while continuing to return capital to shareholders. And, in fact, we are seeing improving revenues for enterprise-facing businesses, driven by a surge in capital spending. This was supported by commentary at a recent Morgan Stanley & Co. conference where nearly half of companies presenting—new and old tech—discussed the cloud as part of their business models. Many tech companies should also benefit from lower tax rates and repatriation of cash held abroad. That should fuel their ability to increase dividends and buybacks.
- Growth utilities. Many investors correctly assume that traditional utilities have limited dividend growth because of higher regulatory scrutiny and high dividend payout ratios. However, there are select higher-growth utilities that have unique assets or revenue drivers, particularly in unregulated businesses. Examples include utilities with wind or solar power assets, as well as those that operate export facilities for liquid natural gas. The economics of wind and solar power continue to improve. Currently, they provide more than half of all new power-generation capacity.
- Global integrated oil. Contrary to many investors currently, we believe energy stocks offer an excellent value. These equities have continued to lag the improvement in both oil prices and earnings. U.S. exploration and production companies have begun to make more rational investments, which we believe may improve sentiment around oil supply and demand. Scaling back on investment will also likely free up cash to be returned to shareholders. From a dividend perspective, we see attractive yields and reasonable dividend-growth outlooks globally across integrated oil companies.
This article was derived from an article in the April edition of “On the Markets.” Ask your Financial Advisor if you’d like to see the full report.