In economically uncertain times, investors turn to companies that reliably distribute profits. But caution is advised when chasing high dividend yields.
Consumer staples companies like Pepsi-Cola are a tried and tested component of dividend strategies.
The biggest losers of the first half of the stock market year were able to make up ground this week. This refers to growth stocks such as those of the vaccine manufacturer Moderna, the Google parent company Alphabet or the Swiss computer accessories manufacturer Logitech, some of which even ended the past five days with impressive gains. Leading indices such as the S&P500, DAX or the SMI ended the week slightly higher.
Various forces are currently driving market activity: Fears of a recession in the United States and other economies are growing. If the economy continues to cool down, there is hope that inflation will soon peak.
Still, an economic downturn is no cause for celebration for investors. In uncertain times, they increasingly turn to less eye-catching companies with defensive characteristics. These include stocks in the consumer staples, healthcare and insurance sectors. In this context, one also speaks of value stocks, which are favorably valued from the point of view of their price/earnings ratio.
A popular investment strategy in the value space is to invest in stocks that traditionally pay a high and reliable dividend from the company’s earnings.
Investors can either build such a portfolio themselves or buy a stock fund that identifies the most reliable dividend payers. Depending on whether the investment vehicle is actively or passively managed, a more or less high management fee is incurred. One of the largest vehicles in this area is the top dividend fund of the fund company DWS with managed assets of almost 20 billion euros. Pharmaceuticals are the most heavily weighted in the portfolio, followed by insurance and communications stocks.
The fund operator charges a fee of 1.45 percent per year for its expertise and promises a dividend yield that should be 1.5 percentage points above the market level. Thomas Schüssler, who has managed the fund for 17 years, justifies the higher costs compared to passively managed funds by saying that it takes a lot of know-how to construct dividend indices that have generated constantly increasing dividends over the years.
Investors should follow several rules when it comes to dividend strategies.
Rule 1: Never buy only the stocks with the highest dividend yields
If a share yields a dividend of five to six percent, it looks attractive at first glance, even in the current high interest rate environment. But caution is advised: According to Schuessler, high dividend yields are often a warning signal. For example, a return may only have increased because the stock price has fallen as a result of poor corporate governance. Then the percentage weight of the dividend increases compared to the price, but in absolute terms it is still the same. A high dividend yield can also be a signal that a company is paying out more than makes economic sense.
Rule 2: Medium-high dividend yields are most attractive when they meet certain criteria
Instead of blindly striving for the highest dividend yield, Schüssler recommends stocks with medium-high yields of between three and four percent. Another important criterion is that the companies regularly increase the absolute value of the dividends over the years. That is a sign of quality, even if the individual increases are small, says the fund manager. If a company doesn’t increase its dividend in absolute terms for two years, it’s not a catastrophe in individual cases, but it’s worth checking the stock more closely.
If you want to identify companies that will continue to pay dividends reliably in the future, you should also pay attention to a good capital structure with a low debt ratio. “The first line of defense is always a strong balance sheet,” says Schuessler.
Rule 3: Share buybacks, combined with dividends, are attractive when the net number of shares is effectively falling
When companies return part of their profits to shareholders, they don’t always do so through dividends, but also through share buyback programs. Normally, when the company repurchases securities from its shareholders, the price of the security in question increases. Companies from the technology sector in particular prefer this form of distribution to dividends because the management often participates in the price development via share and option programs.
Fund manager Schuessler says that a combination of buyback programs and dividends is particularly attractive from an investor’s point of view, although in the case of buybacks you have to be careful that the number of shares actually decreases net.
Rule 4: Dividend stocks are particularly interesting in a moderate environment on the financial markets
Over the past decade, investors with a focus on solid dividend stocks have had lower returns compared to portfolios heavily weighted in technology and growth stocks. According to Schuessler, dividend strategies can play to their strengths above all in a stock market environment in which the broad stock market is growing less strongly and interest rates are moderate. However, he points out that his portfolio will hardly achieve the high real returns of 8 to 9 percent per year in the coming years.
In fact, high inflation in Europe and the United States is leading to a loss of prosperity. Real capital preservation is difficult in this environment, says Schuessler. Commodity stocks in particular are currently offering a certain degree of protection against inflation. Accordingly, he bought shares in this area.
Rule 5: It pays to reinvest dividends
A study by the University of Chicago a few years ago showed that many investors and financial professionals keep the price development of a dividend stock and the dividend payout in separate mental accounts. Psychologically, they see dividends as similar to coupon payments from bonds and therefore often leave the money paid out in the account and use it for consumption. They do not take into account that a dividend payment always results in an equally large drop in the share price. So dividends aren’t a godsend, they come at a price.
In order to take advantage of the compound interest effect, investors would also be well advised to reinvest the dividends paid out in dividend-paying stocks. However, they often leave the money in the account or buy stocks immediately after the distribution that do not pay a constant dividend and pay a premium because many other investors make the same mistake.