Strategic Insights │ Chasing dividends in a post-Covid world

Strategic Insights │ Chasing dividends in a post-Covid world

Published July 29, 2022

“Buy low, sell high”

“Buy low, sell high” is probably the most consistently given advice when it comes to making money in the stock market. It’s so obvious that it sounds like a joke. But in reality, it’s a lot easier said than done.
Behind the truism is the tendency that markets have to overshoot on both the downside and the upside. Part of the reason is a pure herd instinct that drives stock prices. The investor who takes an unbiased look at the market might be able to see the herd instinct at work and take advantage of the extreme ups and downs that it causes. Then, they can indeed buy low and sell high. Unfortunately, it’s easy to determine after the fact whether a price was too low or too high and even why. At the time, it is monumentally difficult. Prices at any given time affect the psychology of people operating on the market, as well as reflecting it, which makes the “buy low, sell high” approach somewhat tricky to adopt consistently. Fortunately, there is another way to make money… and that involves dividends.
Put simply, a dividend is the distribution of a company’s earnings to its shareholders. In other words, investors get a share of their profits. Essentially, each share of the company’s stock that they own entitles them to a percentage of the company’s share price – a set dividend payment. Typically, these payments are made on a regular basis – usually quarterly. Special dividend payments can also be made when a company makes changes to its financial structure or spins off a subsidiary.
These payments can be in cash… or they can take the form of additional shares. Dividend-paying stocks for investors are a little like a back catalogue of music spanning decades for someone like Elton John: they are a way to earn passive income.
Our Chief Investment Officer Peter Lowman frequently advocates holding global income funds within a portfolio that offers our clients a combination of quality growth and value companies with strong balance sheets, cash flows, and rising dividend streams. And just a couple of weeks ago, IQ’s wealth manager Melissa Thorogood discussed leveraging the magic of compounding by reinvesting any excess income from your investments. Indeed, reinvesting dividends is an excellent way to profit from a total return strategy – significantly more so than mere capital market returns.
But they don’t just provide a steady income stream: dividend-paying stocks are particularly relevant right now because they help protect your money against the ravages of rising inflation.

Dividend-paying funds: a lucrative form of income for investors

Over the past couple of decades, the high street – and indeed the stock market – have changed beyond recognition. But take a look at the latter, and you will see that there are still many behemoths out there that seem to survive through thick and thin: companies like Procter & Gamble, Coca-Cola, Colgate Palmolive and Johnson & Johnson are the dividend kings of this world, and they have a long history of paying out consistently, year in, year out. These are companies that can weather (and even benefit from) rising inflation and interest rates. Why? Because they have pricing power. If Colgate decides to increase the price of a tube of toothpaste by 20 pence… most people will pay that extra 20 pence. As the prices of the products and services provided by these companies increase, their company earnings and dividends will generally increase.
Today’s landscape is very different from that at the height of the pandemic. Dividends have recovered significantly (British Gas owner Centrica, for example, has just brought back an interim dividend of 1 pence per share after reporting strong profits), interest rates are rising faster than they have done for many years, and as far as inflation is concerned, it’s the 1970s out there.
At such times, it makes sense for us to focus even more on the funds that we have in our portfolios and the valuations of the companies that our chosen fund managers are paying within their own funds. Through our internal processes, we prioritise high cash flows and well-covered dividends, instead of those companies that focus on high growing future earnings, which are likely to be heavily discounted in the current climate. By way of an example, Netflix – one of the Covid darlings – has suffered badly in recent times and fallen heavily from its all-time high.
More specifically, it is sensible to try and build model portfolios that own funds made up of stocks with strong cash flows which consistently grow dividends (our IQ Distribution and IQ Growth & Income portfolios, for example, are made up of funds with at least two-times dividend coverage). In times of uncertainty, this strategy tends to weather the storm and benefit over the long term.
Companies that exhibit superficially high dividend yields may have flawed business models which contribute to unsustainable payout ratios. Having experienced income fund managers on your side and in your portfolios is key. Examples include the GAM UK Equity Income Fund, which is tilted towards the value end of the market, and the Liontrust Global Dividend Fund, which focuses on investing in innovative businesses or both capital growth and income.

Tech and toothpaste

At Investment Quorum, we apply a “tech and toothpaste” (innovation and consumer stocks) strategy, the relevance of which is all the more apparent in times of higher inflation or market crisis: innovative companies continue to disrupt the market, increasing their market share and their corporate profitability, enhancing investor returns in the process. Businesses with pricing power, meanwhile, will maintain their margins during challenging investment cycles.
Indeed, historically, dividend payments have accounted for some 40% of total stock market returns. It is at times such as these that global investors benefit from having portfolios that include stocks that increase their dividends the most.

Good rules of thumb for investors

While investing in stocks with dividend growth is always a good idea, investment decisions should be made carefully. One should always guard against responding in real-time to events and rebalancing portfolios. The inflationary pressures that we are currently experiencing have been in the offing for some time, and many high-dividend stocks are already valued to reflect this.
The best advice is always to take the long view and build a diversified portfolio of holdings. Resist the temptation to try and time the market and engage in endless tinkering.

Key takeaways

Dividend-paying stocks are a sensible component of any portfolio, especially in the current inflationary environment (rising prices can boost company profits). Today’s uncertainty constitutes good grounds for a focus on stability and resilience, two qualities many income funds display in abundance. BlackRock recently undertook an analysis of the dynamics at play during the great inflationary period of the 1970s. Although the backdrop was very different, it found dividend-paying sectors – such as energy, financials and healthcare – to be among the top performers. These sectors have all performed relatively well over the past 18 months, but analysts believe that dividend payers could actually outpace the broader market even further as we continue to navigate increasingly complex geopolitical tensions and growing uncertainty.
With real yields on high-quality corporate credit and government bonds still negative in most regions, investors seeking stable, inflation-proof income need look no further than well-covered, high-quality dividend income to help them weather the inflation storm.