The Takeaway
- Cherished for their income stream, dividends also contribute significantly to the long-term total return from equity markets.
- Dividend payers tend to be established, steadier-than-average companies, confident enough in their cash flows to commit to returning cash to shareholders.
Over the short term, dividend-paying stocks tend to be overshadowed by high-flying growth stocks; but they are a dependable route to successful long-term equity investing. From the days of the Dutch East India Company, dividends have served as the primary mechanism for businesses to distribute cash to shareholders. Cherished for their income stream, dividends also contribute significantly to the long-term total return from equity markets. Though dividend payers are dismissed by some as slow-growth companies lacking in reinvestment opportunities, their stodgy image belies a long-term performance advantage.
This is not to say that equity income investing doesn’t carry risk. Interest rates are the most commonly feared enemy of the dividend investor. Morningstar research shows that the conventional wisdom regarding the historical relationship between interest rates and dividend payers is flawed.
“Dividend traps” are a more serious concern. A company can lure investors with a tempting yield, only to experience financial distress, dividend cuts, and share price declines. Chasing short-term yield at the expense of long-term total return can lead investors into dangerous corners of the market. Financials and housing-related stocks in 2007-09, energy and materials stocks in 2014-15, and 2020’s pandemic-driven dividend disaster present cautionary tales.
Valuation is also an important consideration. High-yielding stocks can become a crowded trade, especially when cash and bonds offer paltry yields and ageing investors look to their portfolios for income. Of course, avoiding overvalued shares is always a good investment strategy. Buying at a discount to intrinsic value provides a margin of safety and upside potential.
The Morningstar US Dividend Valuation Index represents a rules-based, selective approach to equity income investing. The index offers exposure to companies with significant payouts that are also financially healthy and attractively valued. Financial health is measured by the dynamic Distance to Default indicator, a measure of future distress. Valuation is gauged not through backward looking financial metrics, but through the insights of Morningstar’s Equity Research team. As a result, the Morningstar US Dividend Valuation Index homes in on companies with relatively attractive valuations and superior financial health, which Morningstar research links to dividend sustainability. The Morningstar US Dividend Valuation Index not only outperformed the broader U.S. dividend universe over the back-test period, but the equity market overall.
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