How dividend investors can choose the right companies

During the pandemic, just under 200 companies stopped paying dividends to save money. In the past three years, many of them have resumed dividend payments, but some have not, and total dividend growth is expected to slow to 2.3% in 2023, according to Janus Henderson’s latest Global Dividend Index.

Now, even as the economy continues to emerge from the worst of the pandemic disruptions, continued inflation and higher interest rates are straining corporate balance sheets, which can discourage dividend payments. A handful of companies have recently announced plans to cut their dividends.

Max Wasserman, founder and senior portfolio manager at Chicago-based Miramar Capital, says many of the indefinite pauses and recent dividend cuts are the result of poor capital allocation strategies.

“What you see are companies that have increased their payout ratio so much that any disruption to their business model has jeopardized their dividends,” says Mr. Wasserman. “Some companies have stretched their balance sheets to remain dividend ‘aristocrats’ or to stay on the radar of mutual funds and dividend investors, and that has eroded their cash flows. With higher debt, inflation and uncertainty, they have made the decision to cut the dividend in response.”

Antonio DeSpirito, lead portfolio manager of the BlackRock Equity Dividend portfolios, says the timing of a dividend cut can inform investors about a company’s underlying health. “The work we’ve done on this shows that if a company cuts costs outside of its business cycle, it can be a sign of danger. That usually means there’s a long-standing secondary problem at a company. The stock will recover less quickly,” he says. “If you see a decline in sales during a recession, there’s a greater chance that inventory will recover.”

Look for sustainability

So, what should dividend investors look for in a company? R. Burns McKinney, general manager and senior portfolio manager at Dallas-based NFJ Investment Group, says investors should look at cash flow in addition to the company’s dividend. It can be tempting to look for the biggest dividends or the highest dividend yields, but cash flow is a measure of sustainability, he says.

“The best dividend companies are the ones that have thought about it and have a philosophy behind what they do with their dividend,” he says. “This should be rooted in current cash flow and their expectations for business growth over time.”

Both Messrs. McKinney and Wasserman argue that high-quality dividend payers should meaningfully increase their dividends year over year, ideally keeping pace with inflation. Capital allocation strategies should also consider the possibility of an economic slowdown or recession, they say. For 2023, both expect high-quality dividend payers to increase payouts despite pressure on corporate balance sheets from inflation and debt burdens.

“The increases may not be sky-high,” says Mr Wasserman. “If a company has raised its dividend by 5%, you might see them do 3% this year. But we expect to see increases, if that’s the path they’ve been on.”

A variety of strategies

For fund investors, dividend funds may offer some protection in the current market environment, said Daniel Sotiroff, a senior analyst at Morningstar Research Services, a division of Morningstar Inc. means that these are highly profitable businesses. Investing in them can be a defensive investment in times of uncertainty,” he says. Last year, dividend funds fell 6.68% on average, compared to a 19.4% drop in the S&P 500 index, according to Morningstar.

Investors can follow different strategies with dividend funds. There are funds with a broad scope, such as Invesco Dividend Income Fund (FSTUX), which invests in companies across sectors, including long-term dividend payers such as Johnson & Johnson and Bank of America Corp.

It has an expense ratio of 0.66%.

Dividend yield funds invest in companies that pay dividends at a higher rate than a given benchmark index. Aniket Ullal, head of ETF data and analysis at CFRA Research, says these funds give investors an opportunity to look more from a sector perspective, as many of them invest primarily in one or two sectors.

Vanguard offers a dividend appreciation strategy through its Vanguard Dividend Appreciation ETF (VIG). The fund tracks the S&P US Dividend Growers Index, which includes only companies with a record of rising dividends. The fund holds all stocks in the index and has an expense ratio of 0.06%.

“Each of these strategies is going to play a different role in a portfolio,” says Mr. Ullal. “There can be a trade-off when you focus on returns because you increase concentration risk in a portfolio. Every investor will have to decide if it’s worth it.”

Mrs. McCann is a New York writer. She can be reached at [email protected]