Dividend Investing Finding the sweet spot of income growth and lower volatility

Transcription

1 JUNE 2013 Discover Value. Dividend Investing Finding the sweet spot of income growth and lower volatility Lowell Bolken, CFA Real Estate Securities & Joseph Betlej, CFA Real Estate Securities & Craig Stapleton, CFA, FRM Quantitative Strategies & With central banks holding the line on interest rates, investors have stepped up the search for yield. Bond yields are dramatically below expectations. Investors have driven up equities, suppressing dividend yields. Where can an income-focused investor turn? We believe certain institutional investors can benefit from a strategy based on actively managed, higheryielding equity securities that generate cash flow from real assets. Identifying securities with growth in absolute dividend levels is the key to success. Properly constructing a total return income strategy of higher-yielding equities requires special skills. Higheryielding equities exhibit bond-like characteristics, equity-growth attributes, or a combination of both. Successful investors must apply credit underwriting experience and conduct an expert analysis of future cash flow growth. Insights Dividends can be an important component of total return over the long term. Higher-yielding equities can serve as substitutes for corporate bonds. Finding the right equities requires a unique combination of credit underwriting and equity growth analysis. Individual security selection is crucial to achieve investors goals. Market fluctuations provide opportunities. Lower prices heighten dividend yields. Actively managing such a strategy requires even more expertise. The asset manager must understand multiple industries, know how different stages of the economic cycle affect higher-yielding securities and industries, and be able to position at multiple layers of the capital stack to help mute overall volatility. Cumulative Return Source: Bloomberg Chart 1. Higher Dividend Paying Stocks: Less Volatility, Higher Return 12/2000 3/2013 Dec-00 Aug-01 Apr-02 Dec-02 Aug-03 Apr-04 Dec-04 Aug-05 Apr-06 Dec-06 Aug-07 Apr-08 Dec-08 Aug-09 Apr-10 Dec-10 Aug-11 Apr-12 Dec-12 Volatility of S&P Aristocrats S&P 500 Dividend Aristocrats S&P 500 7% 5% 3% 1% -1% - Standard Deviation

2 PAGE 2 Tapping Into Dividend Power Dividends can be an important component of total return over the long term. According to Ibbotson, 1 since 1926 dividends have accounted for 40 percent of the Standard & Poor s 500 Index return. The S&P 500 Dividend Aristocrats Index (S&P 500 companies that have increased dividends for 25 consecutive years) has outperformed the broader S&P 500 by 182 percent (6.75 percent on annual basis) since late (See Chart 1 on previous page). A portfolio of higher-yielding stocks can also be less volatile than a portfolio of lower-yielding stocks. As the shaded area in Chart 1 shows, dividend-paying stocks in the S&P 500 Dividend Aristocrats were generally less volatile than the broader S&P 500. The difference comes from dividends, which are more consistent than stock price appreciation (or depreciation). Dividend growth also protects against inflation. Ned Davis Research, Inc. suggests that since 1972 stocks with growing dividends have outperformed in all inflationary periods, especially so in times of high (4-6 percent) inflation. 2 The Dynamic Duo: Bond underwriting and equity growth analysis Cash flow analysis is the first step in successfully investing in dividend-paying stocks. Cash flow analysis is as crucial with higher-yielding equity securities as it is in corporate bond underwriting. However, while bond underwriting looks for stable cash flow, stock analysis values potential future cash flow growth. A comprehensive bond underwriting analysis of a company producing sustained cash flow growth would focus on downside scenarios. A bond underwriter would see higher growth as implying higher risk and increased volatility. Credit underwriting values low volatility and greater predictability. To the bond underwriter, the sole benefit of cash flow growth is improvement to debt metrics, such as interest and fixed 1 Source: Goldman Sachs Asset Management, Why Dividend Growth Matters. August Ibid charge coverage. In contrast, equity analysis values cash flow growth. Cash flow growth is imperative to the equity investor. Successfully managing a higher yielding equity strategy combines an emphasis on cash flow with the discipline valued by traditional credit underwriting. This can reap rewards through correctly identifying companies able to grow future dividends without sacrificing credit quality. For example, Chart 2 uses the healthcare REIT (Real Estate Investment Trust) subsector performance as a proxy for high dividend-paying equities. The left scale, Funds From Operations (FFO, a proxy for cash flow after interest expense) shows dividend coverage has generally stayed within a tight 1.0x-1.2x range. Cash flow growth, however, allowed the absolute dividend to grow on a cumulative basis by more than 40 percent. Credit underwriting and cash flow growth analysis together can identify desirable stable dividend growth stocks. The goal from a credit underwriting standpoint is to identify a security that exhibits stable coverage. From the equity perspective, we look for a security with substantial cash flow, which can translate into dividend growth. FFO Dividend Coverage Chart 2. Healthcare REITs: Cash Flow Coverage and Cumulative Dividend Growth 1.4x 1.2x 1.0x 0.8x 0.6x 0.4x 0.2x 0.0x Mar-03 Mar-06 Mar-09 Mar-12 FFO Dividend Coverage Cumulative Dividend Growth Cumulative Dividend Growth

3 PAGE 3 Chart 3 contrasts S&P 500 (using the SPDR exchange traded fund as a dividend proxy) dividend yields with the yield on an investment-grade corporate bond* issued in the second quarter of The bond s spread was 167 basis points (1.67 percent) above the 10-year Treasury yield, for an annual coupon interest rate of 5.3 percent. The 10-year history illustrates the value of compound dividend growth. Assuming the two investments were purchased at roughly the same time, the equity market yield surpassed that of the corporate bond. Chart 3. Dividend Income vs. Coupon Income: S&P 500 (SPY ETF) vs. Investment-Grade Corporate Bond* 7% 5% 3% 1% Apr-03 May-04 Jun-05 SPDR S&P 500 ETF Approx. Yield on Initial Investment Jul-06 Aug-07 Sep-05 Oct-09 Nov-10 Dec-11 Jan-13 Investment-Grade Corporate Bond Yield This shows one of the most significant advantages dividend-paying equities offer: a potential increase in income through the dividend, a benefit not available with a fixed coupon bond. Maximizing that benefit requires assessing the probability of a dividend increase. * Finding Sustained Dividend Growth Dividend investing requires confidence. Knowing a company s business, management discipline, and dividend payout history are important. A comprehensive dividend policy reflects management s confidence in the operation s cash flow prospects. A company s consistent dividend payout history also demonstrates management discipline. Breaking a string of dividend increases (or even worse, suspending a dividend), likely will produce an immediate negative investor reaction. It could also irreparably damage investor confidence in future dividend distribution policies. In addition to knowing the company, industry analysis is important. Investing in a mix of industries can optimize the income growth of a portfolio of dividendpaying stocks, while also limiting potential volatility through portfolio diversification. While investing in multiple industries adds complexity, strategically weighting industries during different points in the business cycle enhances the risk/reward equation. While an efficient market will likely account for the expected dividend growth, industry rotation can present opportunities to exploit a disconnect in relative value. Chart 4 depicts three historically high dividend-paying equity sectors: Master Limited Partnerships (MLPs), electric utilities and REITS. Between March 2003 and March 2013, opportunities arose to use historical yield differentiation to rotate among sectors. In the current low volatility/yield starved environment, yields have converged. Appropriate analysis incorporates the industry s relative cash flow growth prospects, which may drive industry rotation in the portfolio. Only active management can achieve optimal results through industry diversification and sector rotation. Using indices to replicate this approach will not achieve the investor s goal of optimizing income growth with limited volatility. *Sample bond selected and referenced for illustrative purposes only.

4 PAGE Chart 4. Historical Yields by Sector experience greater price volatility. It is also important to note that capital structures give cash flow priority to bond investors. The remaining cash flow is available to shareholders in the form of dividends. In a bankruptcy, equity class claims are subordinated and recovery is questionable. With banks, the amount of leverage they typically carry (and resulting greater subordination) distances equity holders from the underlying collateral. The selection of operating companies with identifiable real assets includes a net asset value analysis of the relevant asset infrastructure. This analysis helps gauge a replacement cost relative to public market pricing of the underlying assets. Modeling asset performance in distressed scenarios can help quantify risk in a distressed environment. Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 SNL REIT Healthcare Mar-08 A Better Grade of Dividend Mar-09 XLU Utility ETF Mar-10 Mar-11 Alerian MLP Index Mar-12 Successful security selection, essential for optimizing growth in yield and income, begins with choosing industries. We prefer dividend-paying equities that generate income directly or indirectly from real assets. The REIT, MLP and utility sectors fit those parameters. Some cash flows in high dividend-yielding sectors are not directly based on assets. Cash flows from banking and financial companies, for example, are driven by financial assets and/or fees. The contrast between real assets and financial assets becomes evident during periods of market stress. It can be difficult to quantify how a security lacking direct ties to real assets will recover from stress, which is why those securities The popularity of yield assets is creating fear that pricing has reached unsustainable levels. We believe the focus on real assets with sustainable dividend growth models can support investment returns over the longer term even in a market correction. A correction may also create opportunities to enter the market, as lower prices drive higher yields. In a market correction, investors holding equities with growing dividends can take comfort knowing that over the longer term, growing dividends can ameliorate market fluctuations. Using up-front credit analysis is equally important in protecting against a correction. Cash flow analysis that includes downside scenarios along with debt covenant tests is just as crucial as the growth assumptions included in upside scenarios. More rigorous cash flow analysis can account for different stages of the economic cycle during the security selection process. Ultimately, in times of economic uncertainty this should help limit large swings in volatility.

5 PAGE 5 Summary Investing in dividend-paying stocks can be a rewarding strategy in today s low interest rate environment. But not all dividend-paying stocks are created equal. Companies with a history of paying growing dividends and those with real assets behind their business model present an attractive opportunity to many institutional investors looking for consistent income, income growth and low volatility. This multi-real asset strategy is managed with a focus on the following goals: higher earnings yield than fixed income investments, inflation and interest rate protection, and lower volatility than the S&P 500, with low correlation to the broader market. At a time when the search for income is so challenging, institutional investors should look closely at dividend strategies to find the one that best meets the organization s risk/ reward needs and long term investment horizon. Finding the right combination of stocks that meets investors risk appetites and income needs takes a special set of talents. Advantus Capital Management has successfully combined our substantial experience and special expertise in credit underwriting and real asset equity investing into our Strategic Dividend Income strategy. For more information, contact: Julie Gerend, Sr. Vice President Business Development & Client Service julie.gerend@advantuscapital.com Steve Moen, Vice President Business Development steven.moen@advantuscapital.com This document is directed at institutional investors and consultants. It should not be distributed to or relied on by retail investors. This document may not be reproduced or circulated without prior written permission from Advantus. No statements or representations made in this presentation are legally binding on Advantus. Unless otherwise stated, all views, projections and opinions are those of the authors as of the date of this document and are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which fluctuate. The value of investments and the income from them can go down as well as up and an investor may not get back the amount invested. Past performance is not a guide to what might happen in the future. This is not intended as a recommendation, offer or solicitation for the purchase or sale of any financial instrument. 400 Robert Street North, St. Paul, MN F IM A Advantus Capital Management, Inc. All rights reserved.