Generating Income in a Low Yield Environment: An Overview of Dividend Paying Stocks
With so few investment options looking attractive, which asset class might prove to be successful in this challenging market?
January 22, 2009
by David J. Abella, CFA, Fund Portfolio Manager & Senior Equity Analyst, Rochdale Investment Management
In the wake of the worst global financial crisis since the Great Depression, where can investors generate income? Investing in a diversified portfolio of higher yielding, dividend-paying stocks has traditionally been a solid investment strategy that has provided a stable and growing income stream in a tax-advantageous manner.
Additionally, dividend stocks have usually had less volatility than broader equity markets, while still providing for some longer-term capital appreciation. However, 2008 was a watershed year for most investments, including dividend stocks. With that said, what is the outlook for this strategy and are the stocks still appropriate for investors seeking yields?
First, we will present a primer on the role dividends play at the company level and what to be on the lookout for. Investors view growing dividends as a sign of the financial strength of a company. In addition, there is a significant stigma attached to cutting dividends and, as a result, a company's management would usually adopt a conservative dividend policy in an expansion, and would avoid cutting dividends in a recession. However, with the onset of the credit crisis followed by the ongoing recession, we are seeing more and more companies cutting or suspending their dividends, with their share prices promptly and severely punished as a result. Is there any safety in dividends anymore?
A cash dividend is a distribution of a company's cash, generated from operating profits or sale of assets, at the discretion of the board of directors. Because a company must invest cash in its business in order to keep it operating (maintenance) and growing (capital expenditures), a sustainable dividend payout needs to be distinctly lower than a company's operating profits in an expansion to build up cash reserve or pay down debts. Now, when the company is less profitable during a recessionary period, it can continue to pay its dividends with a cash reserve or untapped credit.
However, a long period of easy credit lured many companies away from this discipline. Many firms operated on the assumptions that they could always refinance debts or sell assets profitably, squandering their excess cash on dubious projects and untimely acquisitions or share repurchases. As the credit crisis continues, many have found that they are unable to refinance their debts coming due, and their projects or acquisitions are now too expensive with the interest rates they now have to pay. The stock market decline and lack of liquidity also make it extremely difficult to raise additional equity without significant dilution. Furthermore, many companies have loan covenants that would restrict them from paying dividends if they cannot meet certain minimum coverage ratios. For these companies, they have no other choice but to cut dividends with the full knowledge of the significant negative impacts this will have on their stock prices.
While the recession continues to worsen around the globe, we can expect company earnings to decline further this year and more companies will cut or suspend dividends in our view. Investors would be well advised to know that, especially now, dividend stocks should not be viewed as fixed-income securities. Only companies with the most pristine balance sheets with neither significant debt maturity nor large capital expenditures coupled with a stable cash-flow are in a good position to avoid reducing dividends. In addition, any company that may require a government bailout will likely face dividend restriction during the period of the assistance.
This does not mean there is no silver lining in all this recessionary talk. In the current environment, companies that have a strong balance-sheet, a competitive position and a relatively reliable cash-flow have the opportunity to perform well in a more stable market environment. Additionally, valuations are very attractive in these securities, creating opportunities for value investors with longer horizons.
We do feel there is opportunity to build out positions in select dividend paying stocks in the current environment. These select dividend paying stocks can create a portfolio with a steady income stream in a tax-advantageous manner that was mentioned in the opening paragraph. While we try to minimize volatility, we would expect markets to remain unsettled for much of 2009 with continued volatility, albeit at a lower level than last year. However, in the longer term, we would have expectations of an increased return from the capital appreciation portion of the returns as stock values begin to enter a recovery period (and holds for dividend payers in particular).
For more information, visit Rochdale Investment Management.
David J. Abella, CFA, Fund Portfolio Manager & Senior Equity Analyst, joined Rochdale in 1996. In addition to performing equity research for client portfolios, he is a manager of Rochdale's Dividend & Income fund. Previously, Abella spent four years with Merrill Lynch and Paine Webber performing strategic analysis and controller functions and two years as a tax consultant at Arthur Andersen & Co. He received his A.B. in economics with high distinction and his M.B.A. in finance, with distinction, from the University of Michigan. Albella has appeared on Bloomberg Television and CNBC and has been quoted in Dow Jones Newswires, Bloomberg News, The Wall Street Journal, Crain's Business, and Investors Business Daily. Abella holds the Chartered Financial Analyst designation and is a member of the New York Society of Security Analysts and the CFA Institute.