Dividend-Paying Stocks: Where Mitigating One Risk Begets Another

Investing in dividend-paying stocks has long served as a strategy to mitigate equity-market risks. The quarterly payouts can be an indicator of corporate performance and cushion stock-price declines.

“A successful business that issues dividends is showing signs of reduced risk,” says Daniel Peris, senior portfolio manager at Federated Hermes.

Though dividends are voluntary and vary, they are generally paid through thick and thin. Eliot Bishop, a Schwab Asset Management portfolio strategist in San Francisco, was relieved to find that during 2020, the first year of the COVID-19 pandemic, fewer than 10 of the 100 companies in the $64 billion Schwab U.S. Dividend Equity Exchange-Traded Fund (SCHD) had reduced or stopped paying their dividends to pay back the federal stimulus loans they had taken.

However, new risks are on the horizon for dividend investors. The ability or willingness of companies to pay dividends could become less predictable. In what Peris, author of the recently published The Ownership Dividend, terms “a coming paradigm shift,” companies that have no track record for paying dividends may start doing so.

This could make it harder to pick companies that will fulfill their promises to return cash to investors without eating into their profits, failing to pay their debts or otherwise damaging their financial health – and ultimately driving down their own stock prices.

Price performance since 2020 of the Schwab U.S. Dividend Equity ETF (SCHD)

Big Techs Call the Tune

Peris’s book suggests a possible scenario in which the share prices of large-cap tech companies like Alphabet, Meta Platforms and Amazon.com come down from their market-leading highs. To get in on that rally, which was in part fueled by share buybacks, investors sold stock in dividend-paying companies, rendering them out of favor over the last year. “That will now change. If your investment in a particular company is dependent on a buyback for it to ‘work,’ you may be disappointed,” Peris writes.

The Big Techs could start paying dividends to boost their attractiveness by means other than buybacks. Cases in point: dividend announcements on February 1 and February 28, respectively, by Meta and Salesforce.

This represents a departure from tech companies’ tendency to retain cash for product development and buy back stock to keep share prices rising

“You could certainly see that play out,” says Christy Loop, senior director of investments at Willis Towers Watson in Atlanta, of the possibility of some U.S.-listed companies starting to declare dividends in months or years to come. “Shareholders want increased focus on income in the event of failed investments and growth.”

Applying Metrics

As the universe of dividend-paying stocks expands, investors are likely to embrace strategies to manage the risk of investing in them.

“The risk is not having enough cash to pay dividends,” says Zachary Evens, a manager research analyst at Morningstar in Chicago. That’s why investors must employ risk metrics that “get rid of the value traps, stocks that have fallen significantly in price and have artificially inflated their dividends, possibly masking business deficiencies.”

That would lead investors to spend more time screening metrics like dividend yield, which measures a the dividend as a percentage of a company’s share price, and the dividend yield growth rate, or the extent to which companies have increased or lowered their cash payouts to shareholders over the years.

“It is important to avoid choosing only stocks with a high dividend yield, as this can sometimes be more reflective of a falling stock price [denominator] rather than a strong dividend [numerator],” says Chris Floyd, a Franklin Templeton Investment Solutions portfolio manager in San Francisco. “Often the very highest-yielding stocks are actually the most volatile.”

Wide Swings

A case in point: The S&P 500 High Dividend Index, which tracks 80 stocks, has been a five-year roller coaster ride: It rose 21.49% in 2019, declined 11.59% in 2020, jumped 32.85% in 2021, and fell 1.11% in 2022 before a modest 3.9% rebound 2023.

Because first-time payers have no dividend history, and so no record of dependability or surprises, investors are likely to put more resources into ensuring the financial health of companies before investing in them.

“The risk would come around uncertainty or visibility of that future income stream,” Loop says. That could put a greater focus on a company’s return on equity and cash flow compared to its total debt.

The Schwab Approach

Schwab is one of the most effective at managing the risks of dividend investing, says Evens, citing Morningstar data. According to Bishop at Schwab Asset Management, its passive index methodology employs a series of risk screens to select dividend-paying stocks from the Dow Jones U.S. Broad Market Index on the third Friday in March every year. First, Schwab uses a dividend history screen to pick stocks that have paid dividends for at least 10 consecutive years. Then a yield screen is employed to rank stocks according to their annual dividend yield – and to eliminate the bottom half of these stocks.

Then Schwab executes a quality ranking to narrow its selection down to the 100 most attractive stocks. To rank these companies, it calculates a composite score of each company’s cash flow as a percentage of total debt. The process also includes an annualized calculation of the company’s most recent dividend payment, its dividend growth rate and return on equity. To spread out the risk of investing in these stocks, no more than 4% of the Schwab ETF is invested in a single stock, and no more than 25% is concentrated in one industry.

The Schwab ETF returned 11.3% annualized over 10 years through January 31, according to Morningstar. The fund beat the S&P 500 Index’s 10.83% over that period, according to Standard & Poor’s.

The Case for Dividends

Renewed interest in dividend investing is likely to be healthy for the stock market overall. On average, companies that are seen to be reliable payers of dividends have seen their share price rise, while those that disappointed dividend investors have suffered declines.

“We looked at the 30-year period ending December 31, 2022, and found that companies in the S&P 500 that initiated or increased their dividend over that timeframe outperformed those that cut or did not pay a dividend,” says Franklin Templeton’s Floyd.

Investors enjoyed an average 7.69% annual total return from companies that maintained their existing dividend rate throughout that 30-year period. That more than doubled the 3.25% annual total return for companies that did not pay dividends. And investors lost 2.64% on companies that eliminated or lowered their dividends during that period.

Dividends might therefore hold a key to identifying a coming market tailwind.

“Dividend reinvestment, depending on the index, has made up roughly a third of total return over time of stock market performance,” Schwab’s Bishop points out.