As investors, we’re all concerned about how the COVID-19 pandemic will affect the market. On news of cities and states initiating lockdowns and shelter-in-place mandates, the market hit its 2020 low in late March. As our knowledge of treating the virus, availability of testing, and results of social distancing have developed, the market has regained nearly half of what it lost.
Historically, we’re about the same level we were in October 2019. Let that sink in. Historically—October 2019. That’s only seven months ago. Furthermore, for the one-year period, from May 14, 2019 to May 14, 2020 we’re up a little over 1%.
Unfortunately, we still have a lack of clarity on how the economy will rebound. While first-quarter earnings are down nearly 14%, it’s important to remember that the first quarter only contained about two weeks’ worth of pandemic isolation where we saw businesses shuttered. Right now, analysts are expecting earnings from the second quarter 2020 to show the real ugliness of how the pandemic has affected the market, with estimates close to a year-over-year decline in earnings of 42%.
What is interesting is the dividend story. Since March 2020, 33 S&P 500 companies have suspended their dividend, while 12 companies have opted to cut their dividend. Furthermore, 260 companies have maintained or raised their dividend, while 117 are undecided.
Generally, companies pay dividends out of cash flow, which often decreases during economic downturns. However, dividend payouts historically have been much less volatile than stock prices. Dividend payments are commitments made by companies to shareholders; therefore, cutting the dividend often signals financial stress, so it is often the last thing company management will want to do.
Most companies maintain their dividend, provided it does not threaten their ability to maintain the business. It also helps that companies that pay dividends tend to be more mature, with relatively stable sales, earnings, and cash flow. They don’t require profits to grow the business. Consequently, companies that pay dividends are often run by disciplined management teams with shareholder-friendly outlooks.
This is why one of our fundamental criteria for stock selection is financial strength. We always say we want companies that will not only weather the next recession but the next depression. When building an equity income portfolio, our criteria is even more refined. We look closely at a company’s dividend. Companies showing dividend growth within the top 33% of those meeting our investment criteria are considered first. Ideally, their dividend growth rate should be greater than or equal to inflation for high yield dividend companies. We also want to see companies with dividends well covered with cash flow from operations and those having no history of dividend cuts.
Now, as is the case with any investment, valuation should not be overlooked. You don’t want to overpay for any investment, regardless of the strategy. We look for companies with a PEGY—the P/E divided by the long-term growth plus yield—which is an appropriate valuation metric for a dividend-paying stock so that yield is taken into account.
While stock prices can be extremely volatile during market downturns, investors should remember that dividends tend to be much more predictable. A solid dividend return can significantly trim your losses in value. And during a bull market, dividends add up over time as total return accounts for both income from dividends and capital appreciation. About 40% of the broad markets’ return over the past 15 years is generated by dividends.
If you have questions regarding the dividend yield of your portfolio, the experts at Henssler Financial will be glad to help: