Yields on stocks and bonds have converged, causing many income investors to consider portfolio reallocation. A heavier stock allocation provides the potential for greater capital gains and dividend growth. At the same, it potentially increases portfolio volatility. To explore these issues we spoke with David Casesse, one of the portfolio managers for the Blackrock Equity Dividend Fund. With an annual rate of return of 9.25% over the last decade, the fund has few rivals in the large cap value category.
Learn Bonds: Can you describe the investment philosophy of the BlackRock Equity Dividend Fund?
David Cassese: We invest in equities that we believe will consistently grow their dividends. For example, the fund has been a long-term holder of IBM which has increased its dividend from 15 cents per quarter to 85 cents per quarter over the last decade. I would like to point out that the yield on IBM at around 1.64% today, is similar to what it was ten years ago. So we have seen 600% growth in income over that time period, as well as with strong capital appreciation. Those are the types of investment ideas we look to identify.
LB: How do you find stocks that can grow dividends?
David Cassese: To grow a dividend, a company needs to be increasing cash flow. A company cannot pay a cash dividend without free cash flow. To grow cash flow, a company needs to be increasing earnings, which is usually accompanied by topline revenue growth. We look at cash flow, earnings, and revenue. However, cash flow is most important and much harder for a company to manipulate than earnings or revenue. Beyond the numbers, a management’s culture is important. Some companies have ingrained in their culture regularly increasing dividends. We find these companies tend to be more conservative with their finances, and more disciplined with their spending and projections.
LB: Should bond focused investors consider dividend paying stocks?
David Cassese: Yes. There is principal risk when investing in bonds. Because we have experienced a period of generally falling interest rates for the last several decades, I believe that some bond investors don’t consider that they may lose money when interest rates rise. On the other hand, a fund focused on picking stocks with dividend growth should do well during a period of rising interest rates.
David Cassese: Dividend growth has outpaced inflation by around 1 ½ % over the long run. Assuming a long-term inflation rate of 2.5%, dividend growth should be around 4%. While dividend growth should outpace inflation, inflation reduces the real returns of fixed coupon rate bonds.
LB: What is the downside of owning dividend paying stocks?
David Cassese: Dividend paying stocks are more volatile than bonds and have less upside than non-dividend paying stocks during big stock market rallies.
LB: How do dividend paying stocks behave compared to other stocks?
David Cassese: Dividend paying stocks are much less likely to have big drops in value and are less volatile than non-dividend paying stocks. If you look at one standard deviation of market prices, you will see that dividend paying stocks have a standard deviation of 15 – 18%, compared to around 20% for the market as a whole. (Editor’s note, a first standard deviation describes behavior which occurs most of the time.)
LB: Are dividend stocks expensive?
David Cassese: No. There may be a few small pockets, such as utility stocks, where investors may have pushed up prices. Overall, dividend stocks are not expensive. The Price / Earnings ratio is a commonly used measure of a stock’s relative expensiveness. The P/E ratios for the S&P 500 are over 16 ½. The BlackRock Dividend Equity Fund has a P/E of 12 ½.
LB: Can dividends rise?
Yes. The dividend payout ratios, dividends divided by earnings, is near all-time lows at around 30%. In the 80s and 90s , S&P 500 companies paid between 40 to 50% of their earnings in dividends. There is certainly room for companies to raise dividends.
LB: Thank you for your insight.
Learn how to generate more income from your portfolio.
Get our free guide to income investing here.