One of the most popular investment themes across the world is investing in dividend-paying stocks. An indication of this is that four of the ten largest smart beta ETFs in the US have a dividend focus.
A major reason for this is that investing in companies that pay dividends means that you will receive an income stream. This is useful both for anyone needing an income to live off, or those who reinvest the dividends and therefore compound the returns.
However, using dividends as a criterion in stock selection is also a very useful long-term investment strategy because of the kinds of companies that get picked.
“Dividend strategies typically fall into two categories,” says Chris Rule, the head of product and client solutions at CoreShares. “One is a high yield strategy, which selects shares with the highest dividend yield or highest forward yield. The second looks for companies that consistently grow or maintain their dividend in absolute terms, regardless of the size of the yield.”
There are a growing number of strategies that use elements of both of these approaches, but as Rule explains they are actually very different.
“A high yield strategy is more like a value strategy because a lot of the time an abnormally high dividend yield is a function of a low price, not a growing dividend,” he says. “When a company consistently grows its dividends, its capital price is rewarded and it typically moves in line with its dividends. Consistent and stable dividend payers are therefore companies which have more quality-like traits.”
What’s behind the dividend
In South Africa, products that track the FTSE/JSE Dividend+ Index follow the first approach. This index selects companies only on their projected dividend yield.
The CoreShares Divtrax ETF and CoreShares Dividend Aristocrats Tracker Fund, on the other hand, track the S&P South Africa Dividend Aristocrats Index that only includes stocks that have consistently maintained or grown their dividend over the past seven years. These reliable, dividend-paying stocks have very specific characteristics.
“Companies that pay consistent, growing dividends typically have robust, less cyclical earnings, they tend to be more cash generative businesses, have strong balance sheets and low levels of debt,” Rule explains. “They also have very disciplined management teams.”
The kinds of businesses that show these traits are the likes of consumer goods companies, pharmaceutical firms and life insurers. They have products that will be in demand regardless of the state of the economy, and they therefore have relatively consistent earnings.
“An example would be McDonald’s,” says Rule. “It has consistently grown its dividend year on year since 1977.”
These companies also tend to be more defensive in nature. This means that their share prices stand up better in market downturns.
“These strategies will probably lag market cap-weighted indices slightly in a bull market, but they will not fall as much in a market crash,” says Rule. “This gives investors some downside protection.”
This is most clearly illustrated in the US, where the S&P 500 was down 37% for the 2008 calendar year due to the global financial crisis. The S&P Dividend Aristocrats Index, however, lost only 22%.
A global solution
CoreShares’ local Dividend Aristocrats funds have therefore attracted investors who appreciate their more conservative, stable nature. However, these funds are of course restricted by the size of the local market.
There are only a limited number of JSE-listed companies that pay consistent and reliable dividends. They also tend to be concentrated in the financial services industry.
CoreShares is however launching a global Dividend Aristocrats fund that will allow investors to diversify outside of South Africa, but still access the same kinds of quality companies that this strategy delivers.
“Many investors who are buying global strategies are looking for an insurance policy against South African-specific risks,” says Rule. “They are therefore going offshore in a more defensive nature, and this strategy suits that.”
It also offers a diversification benefit for investors who may already be invested in a global market cap-weighted index like the MSCI World.
“The MSCI World Index has a very large technology component, for instance, while Dividend Aristocrats has a very small technology exposure,” says Rule. “So investors will get exposure to different sectors and different companies, and that is great for diversification.”
Brought to you by Coreshares.