The Takeaway
- Buying the shares of companies that are capable of maintaining and growing their income streams into the future is a path to successful long-term equity investing
- Investors would do well to select dividend-paying stocks based on competitive positioning and financial health
Dividend investing isn’t glamorous. Growth themes and innovators capable of exponential returns are far likelier to capture investor imagination than utility stocks or an insurer than has just hiked its payout by 9 cents per share.
Yet investing in seemingly stodgy dividend payers is a far surer route to superior long-term equity returns than chasing the market’s highfliers. The cash payout is the most obvious appeal of dividend-paying stocks—magnified when cash and bonds offer paltry yields and when ageing investors look to their portfolios for income.
But the total-return story is more interesting. Research shows that a substantial portion of the long- term returns from equities comes from reinvested dividends and dividend growth. Dividend paying stocks also possess a performance advantage, with the high-yield segment of the market delivering the best returns. These phenomena are global in nature, spanning Asia Pacific, Europe, and North America.
Yet equity income investing is far from risk-free. While rising interest rates are the most commonly feared pitfall, a more serious risk is the “dividend trap.” A stock can lure investors in with its yield only to see its financial situation deteriorate and payout cut. Chasing short-term yield at the expense of long-term total return can lead investors into dangerous segments of the market. History is riddled with cautionary tales.
For this reason, a selective approach to equity income investing is optimal. Rules-based passive equity income strategies typically employ screens for dividend durability. But the screens tend to be backward-looking. Historical dividend payments and historical dividend growth do not guarantee future payouts.
The Morningstar Dividend Yield Focus Indexes take a uniquely forward-looking approach to dividend investing. By targeting companies with competitive advantages and healthy balance sheets, the index methodology emphasizes dividend payments that can be sustained and ultimately grown over time. The assessment of competitive advantage relies on the insights of the Morningstar equity analyst team, whose proprietary Morningstar Economic Moat Rating measures the durability of the profits that fund dividends. The other pillar of the index methodology, Distance to Default, is a gauge of future financial distress.
This paper updates and expands a 2012 study into the efficacy of the metrics used by the Morningstar Dividend Yield Focus Indexes. The original index was launched in the U.S. in 2010, and the family has since globalized. The data demonstrate that the moat and Distance to Default screens predict dividend sustainability. Like dividend investing itself—which outperforms across markets and time periods—Morningstar’s metrics for quality and financial health have global utility for dividend investors.
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