298 / 708
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It isn’t hard to understand the appeal of dividend
strategies. Couple historically low interest rates
with increasing numbers of income-seeking retirees
and it is no surprise that funds with dividend
strategies have grown in popularity during the past
decade. But income investors will encounter a
varied landscape. At the end of January
2016
, there
were
469
such U.S.-listed strategies across the
open-end, closed-end, and exchange-traded fund
universes, with
$745
billion in assets. These funds
can look and behave differently from one another
depending on how they manage the trade-off
between current income and future dividend growth.
Dividend Growth vs. Dividend Income
Firms that pay out a greater share of their earnings
have less cash to reinvest in their businesses to
fuel future growth. They are also more likely to cut
their dividends than those with lower payout ratios
because they have a smaller buffer should earnings
fall. Plus, high yields can sometimes be a sign of
underlying financial distress. Dividend income port-
folio managers can—and often do—take steps
to limit risk by applying fundamental analysis or
quantitative screens to filter out high-risk names.
In contrast, dividend growth managers are willing to
accept lower current yields in exchange for potentially
higher payouts in the future and generally favor
firms with durable competitive advantages, long divi-
dend growth histories, and strong profitability. In
addition, they often target firms with healthy balance
sheets that suggest they are capable of boosting
dividends. One trade-off is that such quality firms
tend to trade at higher price multiples than stocks
with higher dividend yields. That is certainly the case
currently with consumer staples companies such as
Coca-Cola
KO
and
PepsiCo
PEP
, two popular holdings
of dividend growth funds.
To make these distinctions clearer, we sorted each divi-
dend strategy into one of three equal-sized groups
along the dividend income/growth spectrum: dividend
income, growth and income, and dividend growth. This
score is based on the following portfolio-level metrics:
•
Payout ratio (forward dividend yield/earnings yield)
•
Dividend yield (based on expected payments
over the next year)
•
Return on invested capital
•
Dividend growth of each fund during the past
five years
•
Fund name (whether it is labeled as dividend growth)
Portfolio Comparison
As expected, dividend income funds had a much higher
average (pre-expense) yield and payout ratio than
the broad large-cap market and other two dividend
groups. But their average dividend distributions
slightly shrank during the trailing five years through
December
2015
, which could reflect the impact of
dividend cuts or a shift to lower-yielding names. Con-
sistent with this slight decline, they also invested in
less-profitable firms and had less exposure to stocks
with Morningstar Economic Moat Ratings of wide,
which signifies a durable competitive advantage. Not
surprisingly, income funds tended to exhibit a more
pronounced value tilt than the other two groups.
There were differences in sector allocations as
well. At the end of
2015
, income-oriented funds had
greater exposure to the utilities, real estate, and
energy sectors than growth-oriented strategies and
less exposure to financial, technology, and health-
care stocks. These sector tilts aren’t static. For instance,
in December
2007
, income funds had greater expo-
sure to financial-services stocks than dividend growth
funds, but this tilt reversed after the financial crisis
when many stocks in this sector cut their dividends.
But the managers in each group generally fish in
the same pond over time.
Dividend growth funds’ average valuations and
payout ratios were comparable to the corresponding
figures for the broad large-cap market, and the
group’s dividend yield wasn’t much higher. But this
was the only group with a higher dividend growth
Putting Dividend Funds Through
Their Paces
Morningstar Research
|
Alex Bryan