Changing Landscape in Dividend Equity Investing 

The current secular market backdrop is shaped by elevated real yields, higher inflation, and lower anticipated gross domestic product (GDP) growth. Additionally, stretched equity valuations, a yield curve inversion, and the expected Federal Reserve (Fed) interest-rate policy shift are typically indicative of peak-cycle dynamics.

Since the 1970s, dividend focused equity strategies have had discernable and prolonged periods of out- and under-performance relative to broad markets, as measured by the S&P 500 Index¹ (See Figure 1). Over the last 10 years, large-cap dividend payers have underperformed the broad market, however most of that period was characterized by exceptionally easy monetary conditions. We believe that the end of the era of easy money policies marked an inflection point and a recent policy reset should fuel a more favorable environment for dividend-paying equities in 2024 and beyond.

* Past performance is not indicative of future results. The graph is not intended to represent the performance of any Breckinridge strategy. Evestment defines the U.S. Dividend Focus peer group as “U.S. Equity products that weight their portfolios toward securities with dividend yields at or above the broad market average. REIT and MLP products are excluded from this categorization.” This includes SMAs, mutual funds, co-mingled pools and ETFs. Returns for the Strategy are gross of fees. The index is unmanaged and investors cannot invest directly in it. Index results do not reflect any fees or expenses and generally assumes reinvestment of dividends, income and gains.

In addition to rewarding investors with attractive risk-adjusted returns, dividend-focused strategies have tended to exhibit positive relative performance in down markets, particularly during more severe economic events and periods of longer drawdowns, outperforming the broader market (See Figure 2).

** Past performance is not indicative of future results. The graph is not intended to represent the performance of any Breckinridge strategy. The U.S. Dividend Focus Equity Strategy Evestment defines the U.S. Dividend Focus peer group as “U.S. Equity products that weight their portfolios toward securities with dividend yields at or above the broad market average. REIT and MLP products are excluded from this categorization.” This includes SMAs, mutual funds, co-mingled pools and ETFs. Returns for the Strategy are gross of fees. The index is unmanaged and investors cannot invest directly in it. Index results do not reflect any fees or expenses and generally assumes reinvestment of dividends, income and gains.

The 2023 Dividend Playbook² reported, “Dividend-paying stocks outperform non-payers over time based on two empirical analyses. Stocks that initiate dividends tend to outperform peers after three years.” Further, the analysis showed, “These equities show relative resilience through uncertain market environments.” The authors further concluded that dividends have historically made an outsized contribution to total returns over the medium to long-term and are a key consideration for investors looking for stability and/or income within their portfolios. Specifically, the report noted, “While high yielding stocks can look attractive in the short-term, our work suggests that they tend to offer more volatile, mean-reverting return profiles."

As investors consider their equity allocations, 2024 may be a time to assess both the cyclical as well as the structural benefits of investing in dividend-paying stocks.

Not All Equities Are Created Equal: Emphasis on High Quality

Evolving secular trends combined with maturing business cycle dynamics would suggest that equity investors take a more cautious stance and evaluate the role of high quality equities as a part of the broader asset allocation decision. In the analysis Quality Minus Junk,³ researchers found that, “Quality stocks—those of companies that are profitable, growing and well managed—command higher prices on average than those of unprofitable, stagnant or poorly managed companies” and, further, “have consistently delivered high risk-adjusted returns.” This is evidenced through our own analysis that showed higher Sharpe and Sortino ratios over the last 20 years. 

In equity factor investing,⁴ quality tends to outperform across various phases of the business cycle, as reported in Prime Time for Bonds.⁵ Earnings stability, balance sheet strength, and higher margins typically define companies that are high quality. Other metrics suggesting high quality are gross profitability, return on invested capital, high dividend growth rates, low volatility, and low fundamental risk.

Though definitions of quality vary, strategies targeting quality factors have historically outperformed the market in part because they exhibited greater resilience in periods of adverse economic conditions. Over long time periods, stratified  equity returns of companies considered to be of high quality have tended to outperform companies considered to be of lower quality (See Figure 3 and Figure 4).

*** Past performance is not indicative of future results. Calculations for Figure 3 and Figure 4 were conducted on Factset using Bloomberg Monthly Returns data. High Quality is defined as the top quintile of S&P 500 Index companies that have the following characteristics: strong profitability, low leverage, and low variability in sales/earnings and cash flows. Low quality is defined as companies that are bottom quintile when screened on the same characteristics.

The Sharpe ratio measures risk-adjusted returns to indicate a security’s overall level of volatility.⁶ A November 2023 Asset Allocation Outlook⁷ analyzed structural, long-term exposure to improved risk-adjusted returns across various phases of the business cycle. Based on the findings, since 1984, across three phases of economic expansions and three phases of economic contractions, the average Sharpe ratios for the quality factor were higher when compared to Sharpe ratios for value, momentum, size, low volatility, and low beta. Similarly, Sortino ratio measures downside-risk-adjusted returns and can been seen as a useful metric when comparing factor performance. It is of note that the outperformance of quality stocks has historically persisted across various phases of the business cycle, particularly during economic contractions.

It Is Good To Be a Dividend Payer, but It Is Great To Be a High Quality Dividend Payer

The contention that some dividend payers are also high quality stocks dates back at least 60 years, when Benjamin Graham and his co-authors wrote, “for the vast majority of common stocks, the dividend record and prospects have always been the most important factor controlling investment quality and value.” In the CFAI article titled Analysis of Dividends and Share Repurchases,⁸ the authors write, “Some institutional and individual shareholders see regular cash dividend payments as a measure of investment quality.” While the debate continues about the relationship between dividend-paying stocks and investment quality, largely due to varying definitions of quality, we believe that earnings retention and dividend policy are imperative to investor perceptions of stock value.

In fact, more than 40 percent of the cumulative total return of the S&P 500 for the period from 1930 through 2022 stems from the reinvestment of dividends, exhibiting the power of the compounding effect and the benefits of a structural allocation towards dividend paying equities, according to The Power of Dividends, Past, Present and Future.⁹ In addition, the same report finds that over time, stocks offering the highest level of dividend payouts underperformed those that pay high, but not the very highest, levels of dividends. While the highest dividend payers had higher payout ratios, dividend payments were not sustainable at those levels, and were followed by dividend cuts and negative stock price response in downturns. Our analysis shows that the highest dividend yielding companies have elevated payout ratios and these companies have underperformed the 2^nd and 3^rd highest dividend yielding cohorts over a 20 year horizon on both  an absolute and risk adjusted basis (See Figure 5).

Dividend stability and/or growth is generally indicative of companies that have increased free cash flow and prudently managed balance sheet strength over time. Companies paying dividends, historically, have exhibited less volatility than their non-paying counterparts. (See: The Value of Utilizing Credit Research in Identifying Stable and Growing Dividend Payers.)

Leveraging Our Fixed Income Heritage in Building Equity Portfolios

Our strategy focuses on a subset of U.S. large-cap equities with established dividend payment track records, which we believe are high quality companies. Overemphasis on dividend yield can lead to underperformance over the long run  because elevated payout ratios can prove unsustainable, thus balancing dividend yield and payout ratios with strong Return on Equity (ROE) and dividend growth histories become important in our security selection process.

Additionally, to deliver exposure to companies that exhibit high dividend quality attributes, it is imperative to integrate a measure of financial robustness. We accomplish that with the addition of our proprietary credit rating, which includes a comprehensive forward-looking assessment of the financial strength and management of companies being considered for inclusion in the strategy (See Figure 6).

The proprietary credit rating is determined by our internal team of credit analysts who regularly review company filings and other key metrics to assess the financial strength and creditworthiness of corporate issuers relative to sector peers. Credit analysts evaluate the ability of a company to make interest and principal payments on its debt obligations, which we view as indicative of a company’s capacity to sustain its dividend payments.

Breckinridge’s High Quality Dividend strategies are built using a disciplined investment process that seeks to uncover high quality companies with a track record of reliably delivering dividend income. While some dividend equity strategies may factor in a quality component derived from financial ratios, our strategies integrate the views of our credit analyst team based on their qualitative and quantitative credit quality assessments. Balancing their views with key measures of operational quality and dividend policy underpins our ability to build and manage portfolios of high quality dividend paying stocks that we believe are resilient with a goal of generating reliable income streams while preserving the opportunity for long-term capital appreciation.

[1] The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. Itis a market-value-weighted index with each stock’s weight in the index proportionate to its market value. You cannot invest directly in an index.

[2] 2023 Dividend Playbook, Nicholas Lentini, CFA, et al., Morgan Stanley & Co. LLC, September 27, 2023. The two empirical analyses were based on Compustat data from 1990 through 2022 and Morgan Stanley research. The first showed that stocks that have consecutively grown their dividend for 25 years have consistently outperformed the Standard & Poor’s 500 Index. The second analysis showed that stocks with a high dividend growth factor outperformed stocks with a high dividend yield factor persistently since 2010.

[3] Quality Minus Junk: 10 Quality-Sorted Portfolios, Monthly, AQR Capital Management, January 31, 2024.

[4] Equity factor investing is the strategy of targeting securities with specific characteristics that help explain differences in security returns such as value, quality, momentum, size, and volatility. Approaches to defining factors vary, but are generally supported with evidence of historical outperformance or reduction in risk.

[5] Prime Time for Bonds, Erin Browne, Geraldine Sundstrom, Emmanuel Sharef, PIMCO. November 2023.

[6] The Sharpe ratio uses the following comparison: the return of an investment less the risk-free rate is the numerator. The denominator is the standard deviation of returns.

[7] Asset Allocation Outlook: Prime Time for Bonds, Erin Browne, Geraldine Sundstrom, and Emmanuel Sharef, PIMCO LLC, November 2023.

[8] Analysis of Dividends and Share Repurchases, Gregory Noronha, PhD, CFA, and George H. Troughton, PhD, CFA, 2020.

[9] The Power of Dividends: Past, Present, and Future, Hartford Funds, December 2022. The analysis divided dividend-paying stocks into quintiles based on dividend-payout levels. The first quintile (top 20 percent) consisted of the highest dividend payers, while the fifth quintile (bottom 20 percent) consisted of the lowest dividend payers. The second-quintile stocks outperformed the S&P 500 Index 80 percent of the time during the period from 1930 to 2022, while first- and third-quintile stocks tied for second, beating the S&P 500 Index 67 percent of the time. Fourth- and fifth-quintile stocks lagged significantly, per the study’s results.

#BCAI-03152024-Y6Y3VL6L (4/8/2024)

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This material provides general information and should not be construed as a solicitation or offer of Breckinridge services or products or as legal, tax or investment advice. The content is current as of March 24, 2023, or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice.

The charts contained herein have been provided to illustrate the history of dividend payments and should not be construed as a representation of any client account or Breckinridge strategy. No assurance can be made that any Breckinridge strategy will deliver similar or better results.

There is no assurance that any estimate, target, projection or forward-looking statement (collectively, “estimates”) included in this material will be accurate or prove to be profitable; actual results may differ substantially. Breckinridge estimates are based on Breckinridge’s research, analysis and assumptions. Other events that were not considered in formulating such projections could occur and may significantly affect the outcome, returns or performance.

Past performance is not a guarantee of future results. Breckinridge makes no assurances, warranties or representations that any strategies described herein will meet their investment objectives or incur any profits.

All investments involve risk, including loss of principal. Diversification cannot assure a profit or protect against loss. Fixed income investments have varying degrees of credit risk, interest rate risk, default risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities.

Equity investments are volatile and can decline significantly in response to investor reception of the issuer, market, economic, industry, political, regulatory or other conditions. In addition, when interest rates rise, equity investments, including dividend-paying securities, may become less attractive to investors as bonds and other fixed-income investments may offer higher yields. There is no guarantee that a company will continue to pay, increase or declare a dividend.

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There is no guarantee that integrating ESG analysis will improve risk-adjusted returns, lower portfolio volatility over any specific time period, or outperform the broader market or other strategies that do not utilize ESG analysis when selecting investments. The consideration of ESG factors may limit investment opportunities available to a portfolio. In addition, ESG data often lacks standardization, consistency and transparency and for certain companies such data may not be available, complete or accurate.

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