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|
|Year to Date|
|Number of Companies|
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.
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.
Kevin R. Caron, CFA
Senior Portfolio Manager
Senior Portfolio Manager
Steve Lerit, CFA
Senior Risk Manager
Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income
Senior Portfolio Manager
Municipal Fixed Income
Internal Relationship Manager
Director, External Sales and Marketing
External Sales and Marketing
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