The S&P 500 is up almost 20% this year, yet dividend paying stocks are not participating in this rally. How would you describe what’s happening in the equity markets?
The first half of 2023 was certainly an unusual market environment. The market was up about 17% through the first half of the year, now over 20% through July. Much of that was driven by multiple expansion, where the market’s valuation expands, as opposed to earnings growth. Specifically, the S&P 500 ended 2022 trading around 16.5 times forward earnings estimates. Today, it trades closer to 19 times, well above its 15-year average of 17 times. It’s been a very strong market environment for select sectors and groups of stocks. Most notably, Technology, Communication Services, and Consumer Discretionary were the top performing sectors in the first half of the year. Many sectors did not have such strong gains, and many of those sectors include dividend paying stocks.
How do you value dividend stocks, and what are valuations looking like now?
With the broad market’s advance so far this year, the buzz around artificial intelligence within the technology sector, and, of course, interest rates at higher levels, dividend stocks have been pressured. We think the unusual relative underperformance versus the broad market has created an attractive opportunity for dividend stocks. We value dividend stocks by looking at the company’s dividend yield divided by the market’s dividend yield using the S&P 500. We look at that ratio over a company’s history. When a company is trading at the high end of its relative yield historical range, that usually means its valuation is low, and there’s a good margin of safety for that stock. Conversely, if a stock is trading at the low end of its historical relative yield range, that valuation is high, and there’s not as much of a margin of safety.
Right now, dividend stocks, in general, are trading at very attractive relative yields. For example, the Madison Dividend Income strategy had a yield of 3% at the end of the second quarter, and the S&P 500 yield was closer to 1.5%. That’s 2 times the dividend yield compared to the S&P 500, which is historically high – the highest since we’ve been managing the strategy, which dates back over a decade.
Dividend strategies are often compared to bond strategies based purely on yield. With bonds yielding more than the stock market average, how do you make the case for dividend strategies?
As we sit here today, the yield on the 10-year Treasury is 4%. So, investors can invest their money for 10 years and lock in a 4% interest rate guaranteed by the U.S. government. The Madison Dividend Income strategy is yielding 3%. Dividends are, of course, not guaranteed and can fluctuate. But on average, our companies increased their dividends by 8% over the past year. Increasing dividends is something that we look for in stocks. Another factor to consider is the historical make-up of returns. Selling a bond before maturity can result in price appreciation, especially with wide moves in interest rates, but for the most part, the income makes up the majority of total return. Historically, stocks have returned roughly 10% per year if you look at the S&P 500. The make-up of that return is roughly 7% to 8% from capital appreciation and 2% to 3% from dividends.
In addition to dividend yield, what other fundamental qualities are you looking for when selecting companies for this strategy?
Madison Dividend Income is a conservatively managed equity strategy. We want to own a high quality portfolio of above-average dividend stocks, trading at below-average valuations. And we try to define high quality objectively. For example, Standard and Poor’s provides financial strength ratings for companies. 86% of holdings in the Dividend Income portfolio are rated A- or better by Standard and Poor’s, which compares to just 32% for the S&P 500. So based on financial strength, we think we’re objectively much higher. And that financial strength is important because stocks with the strongest balance sheets have tended to hold up the best in market corrections and bear markets. We focus a lot on protecting capital on the downside. We’re willing to lag in strong up markets as long as we can protect capital in down markets. We believe limiting drawdowns in challenging market environments is the best way to generate attractive long-term returns. In addition to financial strength, we look at a company’s sustainable competitive advantage. Morningstar provides moat ratings for companies, and “wide moat” is the highest rating they award. 67% of the portfolio holdings are rated “wide moat” by Morningstar compared to just 27% for the S&P 500. So based on that measure, we are higher quality.
From a dividend perspective, we want to find stocks with an above average dividend yield, and we defined above average as 1.1 times the S&P 500 dividend yield at the time of purchase. The last thing we look at is dividend growth. Our companies have grown their dividends 8% over the last year on average. We want to find companies with a good historical record of consistently growing their dividends.