Focus on Flexibility Over Yield
The best-performing stocks since the beginning of the pandemic have had one thing in common — a high degree of financial flexibility. The worst-performing stocks were the least flexible. Before we start, it is important to define “flexibility.” For us, it has always meant low debt and high profitability. These characteristics tend to build buffers that help ensure survival during difficult times.
Where to Find Flexibility
Technology stocks, for example, have been a good place to find flexibility lately. The average technology company is very profitable, with very little debt. The sector’s return on assets (10.6%) is higher than any other sector, and net debt is 4% of capital. When the market looked for flexibility at the onset of the pandemic and recession, the tech sector had it with room to spare. While valuations are at the high end, the tech sector still sits at the top of our list of most flexible sectors due to high profitability and ultra-lean balance sheets.
Another way to consider flexibility is by credit rating and balance sheet strength. The chart below shows the average decline in stock prices from the start of the year through the March 23 bottom. It is very clear that declining credit quality and financial flexibility translated into steeper stock price drops and slower bounce-back.
Average Stock Returns by Credit Rating
Standard & Poor’s Ratings
| Rating Category | Decline Phase (12/31-3/23) | Year to Date (12/31-7/24) | Number of Companies |
|---|---|---|---|
| AAA | -19% | +14% | 2 |
| AA | -27% | +1% | 18 |
| A | -34% | -8% | 126 |
| BBB | -39% | -13% | 233 |
| BB | -43% | -13% | 54 |
| B | -56% | -37% | 6 |
| ===== | ===== | ||
| Average | -30% | 0% | |
| Source: Bloomberg |
Don’t Fixate on Yield
As interest rates fall it is natural to look for yield, but it is important not to confuse yield with safety. The argument for safety in yield goes something like this:
“The dividend gives me downside protection because a stock price drop would increase my yield and attract new buyers. Therefore, dividends provide downside protection.”
But dividends did not provide downside protection this year, and often led to greater risk. Dividend yield plays since March, especially high yielding stocks, generally performed very poorly with lots of risk. In many cases, dividend payments provided little cushion and were insufficient to compensate for considerably higher risk. Dividend yields were not a signal of conservative investing, but aggressive risk-taking among yield-hungry investors. High yielding stocks performed more like low-quality, high-yield bonds and less like high-quality, conservative investments.
Consider this year’s return on high-yielding stocks. From December 31, 2019 to the March 23 market bottom, the 50 highest yielding S&P 500 stocks declined far more than average. The average decline was 55% for the 50 highest yielding dividend yield stocks (pre-pandemic), far more significant than the 30% average stock decline. At the time of this writing, the average return of the 50 highest yielding stocks is still down -30% with the S&P 500 now back to break even. The 5% starting dividend yield provided precious little protection in the face of uncertainty.
Could it be that flawed dividend policies before the pandemic compounded the risk of loss among dividend plays?
We think so.
How Dividend Policy Can Create Risk
There is a simple reason why high dividend payouts can create high risk. When the dividend decision at a company takes precedence over financing and investment decisions, either flexibility or growth is sacrificed. Consider that whenever a company pays a dividend or buys back stock, it surrenders cash on hand. This, in turn, reduces financial flexibility. By contrast, a strong cash position provides safety against unexpected shortfalls and “dry powder” for exploiting growth opportunities. A healthy cash position and low debt can be especially valuable during a business downturn when credit may be harder to come by.
This is not to say that all dividends are bad — far from it. However, dividend decisions should follow investing and financing decisions. When the cart gets put before the horse — when dividends at all costs precede investing and financing questions — something is bound to suffer. Shareholders will ultimately bear the cost for misguided policies that prioritize dividend payments over conservative financing or profitable investment decisions. Unfortunately, the downside for misguided policies often materializes only when business conditions sour.
In the end, dividends will not make a financially inflexible company more flexible. But it can serve to make a firm less flexible or slower to grow. Dividends are cash outflows from a business and do not create any new sources of funds from which growth investments can arise. For this to happen, firms must also make right choices about investing back into their business. Since equity investing requires both survival and growth, balancing dividend policy with sound financing and investing decisions is key. This is why we tend to focus more on balance sheets and profitability than a stock’s dividend yield.
Summary
This year is reminding us again just how financial flexibility and quality is becoming more and more important. To us, the old rules of thumb about dividends as a conservative way to invest no longer seems to make sense, especially as the number of top-rated, high-quality credits has shrunk and debt levels continue to climb. Well after the current crisis is past, the legacy of increased debt is likely to remain with us, further intensifying risks. This riskier environment, in our view, requires us to place a greater premium on flexibility and growth while avoiding the temptation to chase yield in this low-rate environment.
Disclosures:
WCA Barometer – We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. Analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.
Standard & Poor’s 500 Index (S&P 500) is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.
S&P Global (SPGI) is a leading American provider of financial information, analytics, and credit ratings, headquartered in New York, NY. It operates major divisions including S&P Global Ratings, S&P Global Market Intelligence, S&P Global Commodity Insights, S&P Global Mobility, and S&P Dow Jones Indices.
The ICE BofA U.S. High Yield Index is an unmanaged index that tracks the performance of U.S. dollar denominated, below investment-grade rated corporate debt publicly issued in the U.S. domestic market.
The S&P 500 Growth measures constituents from the S&P 500 that are classified as growth stocks based on three factors: sales growth, the ratio of earnings change to price, and momentum.
The S&P 500 Value Index measures constituents from the S&P 500 that are classified as value stocks based on three factors: the ratios of book value, earnings and sales to price.
The S&P 500 Equal Weight Index is the equal-weight version of the widely regarded Standard & Poor’s 500 Index, which is generally considered representative of the U.S. large capitalization market. The index has the same constituents as the capitalization-weighted S&P 500, but each company in the index is allocated a fixed weight of 0.20% at each quarterly rebalancing.
The WCA Rising Dividend Custom Benchmark is a rules-based benchmark constructed by Washington Crossing Advisors to represent a universe of large capitalization U.S. companies that meet certain quality and dividend growth criteria, including proprietary screens for profitability, earnings consistency, and balance sheet strength, along with minimum market capitalization and dividend growth requirements. The benchmark is reconstituted and rebalanced quarterly and is intended to serve as a style-appropriate benchmark for the WCA Rising Dividend strategy.
The Washington Crossing Advisors’ High Quality Index and Low Quality Index are objective, quantitative measures designed to identify quality in the top 1,000 U.S. companies. Ranked by fundamental factors, WCA grades companies from “A” (top quintile) to “F” (bottom quintile). Factors include debt relative to equity, asset profitability, and consistency in performance. Companies with lower debt, higher profitability, and greater consistency earn higher grades. These indices are reconstituted annually and rebalanced daily. For informational purposes only, and WCA Quality Grade indices do not reflect the performance of any WCA investment strategy.
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Standard deviation is a measure of the volatility of a security’s or portfolio’s returns in relation to the mean return. The larger the standard deviation, the greater the volatility of return in relation to the mean return.
Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments
This commentary often expresses opinions about the direction of market, investment sector, and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.
The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.
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