Dividend ETFs: seeking quality in uncertain times

As we make our way through the new year amid continued market uncertainty and the prospect of a recession still looming, investors are increasingly looking for stable and dependable stocks with which to bolster their portfolios. Dividend-paying stocks have long been a popular choice in environments like these, and for good reason: Companies that can pay dividends throughout the market cycle tend to be of higher quality, offering investors a degree of reliability in times of market turbulence. It’s important that investors don’t get distracted by the lure of high dividend yields alone, however, as they rarely tell the whole story.

The vast majority of dividend ETFs in the market today are passive, meaning they rely on a rules-based index methodology to construct a portfolio, typically selecting the highest-yielding securities within the investment universe for inclusion within the portfolio.

We believe such an approach can fail to take into account potential underlying risks that an attention-grabbing dividend yield may mask. For instance, is the dividend payout sustainable? Is the dividend yield unrealistically high due to concerns over the long-term viability of the company? Is a high dividend being funded through debt?

In our view, taking a more diversified active approach to selecting a portfolio of dividend-paying stocks allows managers to look beyond the yield generated by each individual name. This involves taking a closer look at the underlying factors behind a company’s high dividend yield. These can include quality-oriented metrics that, when considered in tandem with dividend yield and dividend growth, can help construct a portfolio that not only offers a sustainable stream of income, but also has the potential for price appreciation.

The value of dividends

Dividend stocks provide two separate sources of return: price appreciation as well as income from dividend payments, which can be reinvested or received. As we mentioned earlier, our view is that dividend stocks shouldn’t be selected based on dividend yield alone. By using a range of quality-based fundamental measures such as coverage and payout ratios, return ratios, leverage, and margin metrics, a portfolio may turn its focus toward capital appreciation and, potentially, a more stable path during financial storms.

Although dividend payments can provide a signal of quality to investors, price return remains the primary driver of total return and should be taken into consideration when constructing a dividend portfolio. As we mentioned earlier, our view is that dividend stocks shouldn’t be selected based on dividend yield alone, but also taking into account the potential for capital appreciation and a range of quality-based metrics, including interest coverage, payout ratios, return on investments, return on equities, debt to equity, high margins, and changes in margins over time.

Diversification is also an important factor. Many passive dividend ETFs end up favoring particular sectors, such as financials and energy, where dividend-paying companies are more often found. This sector concentration can be risky if that area of the market lags, potentially hurting a portfolio’s overall return. The first half of 2023 saw much of the market’s return driven by a handful of mega-cap stocks, but by the time the market rallied in Q4, returns had broadened widely. An active manager can diversify risk exposures and identify companies with solid balance sheets and resilient business models and seek out those at attractive valuations.  

The search for quality

Looking ahead, we expect earnings growth will be a key cause for concern in equity markets during the next few quarters of 2024. Despite sluggish revenue growth in the second half of 2023, company earnings actually proved to be resilient as executives were able to implement expense management initiatives. Those initiatives have now run their course, resulting in the likelihood of S&P 500 Index profit margins coming under pressure from current elevated levels as revenue growth languishes. As a result, we believe earnings growth will be flat to slightly negative during the first half of the year.

In this environment, stock selection will remain key and may present important opportunities in 2024 for quality companies with strong balance sheets. We need to look no further than the most recent earnings cycle, where the market rewarded S&P 500 Index companies with positive earnings surprises (more than the average) and penalized those with negative earnings surprises (more than average) for evidence. When the global economy slows, revenue growth declines and profit margins decrease, leaving the company with less cash to pay debt obligations and to sustain the business. Quality dividend payers with strong balance sheets are therefore better equipped to withstand sustained pressure and have historically performed well prior to, during, and after periods of negative growth. What’s more, these companies typically remain resilient through different economic cycles, have a high percentage of recurring revenue, the ability to invest in organic growth while expanding margins, and have the chance to grow market share. 

It’s not about finding dividends; it’s about finding the right dividends

Dividends are an established and important source of income for Canadian investors, particularly in times of market uncertainty. But with most dividend ETFs being passive, they generally seek to achieve their dividend yield by exclusively targeting stocks paying the highest dividend yields. As we’ve explained, we believe such a single-factor approach can miss underlying risks.

In our view, considering dividend yield together with quality-focused metrics such as interest coverage, payout ratios, return on investments, debt to equity, and margins can result in investors benefiting from companies that have stronger fundamentals and more sustainable dividends.