Rising dividends attract investors seeking income
Market Perspectives - November 2011
Rising dividends attract investors seeking income
Companies around the world learned hard lessons in the financial crisis of 2008, including the importance of carefully managing debt. Corporate profitability overall now is high and balance sheets are the strongest they have been in decades. Many companies are using their cash for dividend payments, providing income for investors during this time of low interest rates.
For example, the trailing 12-month dividend per share for S&P 500 companies has risen modestly since 2009.1 In addition, the companies that are components of the dow Jones Industrial Average now are forecast to distribute $102.7 billion in dividends during the 12-month period that began october 1, 2011 – a year-over-year increase of nearly 12 percent.2
The slow pace of global economic growth is likely to mean slower corporate earnings growth in the years ahead, which may add to the potential appeal of dividends. For example, earnings for S&P 500 companies in the second quarter of 2011 showed a 19 percent increase from the same period a year ago, while earnings for the third-quarter are showing a 15 percent increase.3
Building an income stream
Investors often use their portfolios as sources of income, especially during retirement. The extremely low interest rates in recent years have made it difficult for many to meet their income objectives solely through purchases of corporate or government bonds, or by investing in fixed-income mutual funds. Dividend-paying stocks, and the mutual funds that invest in them, may be an additional source of income.
In September 2011, dividend payout ratios – the dividend payment per share divided by earnings per share – for the S&P 500 companies were at or near all-time lows, implying ample flexibility for future dividend hikes or share repurchases. In addition, 22 percent of dividend-paying S&P 500 stocks had a dividend yield – the payout as a percentage of the stock price – that was higher than the 10-year corporate bond yield.4
That yield gap has narrowed as the U.S. stock market has come off its recent lows. For example, in late October the 10-year Treasury bond yield was around 2.3 percent, the 10-year corporate bond yield was about 3.8 percent and the S&P 500’s dividend yield was near 2.2 percent.5
But outside the U.S., companies with low or no debt and free cash flows also are paying dividends, and often at much higher yield rates than U.S. companies. The differences in many cases reflect the changing economics around the globe, with growth in developing and emerging markets driving demand for the products and services of multinational firms.
Dividends and mutual funds
Put simply, companies can share their profits with stockholders – including stock mutual funds – by making cash payments in the form of dividends. The stock mutual funds that receive these dividends then are required to pass them along to fund shareholders in regularly scheduled payments – typically quarterly, semiannually or annually. Shareholders also usually can choose to reinvest their dividends in the fund or take them as cash payments. Mutual funds specializing in dividend stocks have seen inflows of $23.6 billion through Sept. 30, 2011, or twice as much as in all of 2010.6
John Maxwell, portfolio manager for the Ivy International Balanced Fund, says he has continued to pursue dividend-yielding stocks in the equity portion of the Fund as a source of income. he says equities remain inexpensive when compared to bonds now. “By increasing the focus on yield through equities, we are looking to increase the income level of the Fund,” Maxwell says. “I’m also optimistic about yield prospects in the near term, as dividends have been a big part of our stock selection criteria over the last 12 months,” he says.
Maxwell notes that “the dividend play” – seeking yield through dividends – potentially can provide an alternative for income now. Dividends from strong companies can offer higher income potential than the low yields on treasuries, he says, without the extra risk and leverage associated with high yield instruments, which now yield about 8.7 percent.7
Past performance does not guarantee future results. The hypothetical investments are for illustrative purposes only and are not indicative of any investment. The illustration does not take into account the effect of taxes or transaction costs and also does not consider the possibilities for investment growth associated with investing the dividends paid in cash in other performance vehicles. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered to represent the U.S. stock market. MSCI EAFE is an unmanaged index comprised of securities that represent the securities markets in Europe, Australasia and the Far East. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used to create indices or financial products. This report is not approved or produced by MSCI. Investments cannot be made directly in an index.
Chace Brundige, portfolio manager of the Ivy International Growth Fund and the Waddell & Reed Advisors International Growth Fund, says, “In my opinion, the biggest risk to income investors today is eventual inflation. With dividend-paying stocks you at least have a fighting chance to benefit through the potential for rising dividends and stock prices.”
While not calling for the immediate return of inflation, Brundige says that it is a risk in the future as government leaders work to re-ignite economic growth. And dividend-paying stocks can offer some inflation protection, he says. For example, as prices rise with inflation, corporate earnings often rise and allow dividend payments to increase. Interest payments on bonds, however, remain static unless they are inflation-indexed or carry a variable rate, which most do not. In addition, if a company has pricing power for its products and can maintain or even grow profit margins during inflationary times, its share price may rise — but bond prices typically fall.
While fixed-income investors who are concerned about inflation often invest in very short-term or inflation-indexed securities as a way to counter that risk, those types of securities offer very low yields now.
Dividend payments also can be a positive indicator of a company’s financial health. In part, this is because the company’s management is forced to focus on making money now to support the dividends. It’s important to research a dividend-paying company thoroughly to ensure the company has the growth potential to maintain those payments. The research can uncover stocks at multiple points in the dividend process, including:
- Dividend payers — companies with a long history of growing dividends at rates significantly higher than inflation
- Dividend growers — companies whose long-term business prospects offer the potential to increase their dividend at rates higher than inflation or to begin paying a dividend in the near future
The stock selection process followed by portfolio managers and analysts at Waddell & Reed includes a thorough review of fundamental factors.
Maxwell says he selects the stocks for the Ivy International Balanced Fund and the Ivy International Core equity Fund, which he also manages, after researching companies that demonstrate strong cash flows, less leverage on their balance sheets and solid opportunities for growth. Those features are among the indicators that demonstrate a company can support ongoing dividend payments.
The case for dividends now
In the current environment of volatile markets and an uncertain global economic outlook, Waddell & Reed continues to think that companies with strong business models and brands, clear market opportunities, strong cash flows and the operational ability to fuel revenue growth will prosper.
Dividends paid on the stocks of such companies can contribute to an investment income stream, add diversification to the stocks component of a portfolio and reduce volatility. Remember, diversification does not ensure a profit or protect against loss, although it can help reduce the overall risk and volatility of your investment portfolio.
Data quoted is past performance and current performance may be lower or higher. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, and shares, when redeemed, may be more or less than their original cost. Please visit www.waddell.com for the Funds’ most recent month-end performance.
Performance at net asset value (NAV) does not include the effect of sales charges. Class A share performance, including sales charges, reflects the maximum applicable front-end sales load of 5.75 percent.
JP Morgan GBI Global Ex US TR USD is an unmanaged index comprised of securities that represent the global market excluding the U.S. MSCI AC World Ex USA is an unmanaged index comprised of securities that represent the securities markets around the world excluding the U.S. MSCI EAFE is an unmanaged index comprised of securities that represent the securities markets in Europe, Australasia and the Far East. MSCI EAFE Growth is an unmanaged index comprised of growth securities that represent the securities markets in Europe, Australasia and the Far East. It is not possible to invest directly in an index.
1 Source: International Strategy and Investment Group
2 Source: “dream of no Credit Risk,” Barrons.com, oct. 22, 2011
3 Sources: “Weekly economic Report,” International Strategy & Investment, Aug. 15, 2011; “third quarter of ’11 S&P 500 earnings Snapshot,” Bloomberg, oct. 26, 2011 4 Source: Morningstar Inc.
5, 7 Source: Barclays Bank plc
6 Source: Strategic Insight
Past performance is not a guarantee of future results. The opinions expressed in this article are those of Waddell & Reed and its fund managers, and are not meant to predict or project the future performance of any investment product. The opinions are current through Nov. 2, 2011, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.
Consider all factors. Dividend-paying investments may not experience the same price appreciation as non-dividend-paying instruments. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investment return and principal value will fluctuate, and it’s possible to lose money by investing.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for the mutual funds offered by Waddell & Reed, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.
Ivy Funds are managed by Ivy Investment Management Company and distributed by its subsidiary, Ivy Funds Distributor, Inc.
Waddell & Reed Investment Management Company, a subsidiary of Waddell & Reed, Inc., serves as the investment advisor to the Waddell & Reed Advisors Funds.