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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 CategoryDecline 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.

Kevin R. Caron, CFA
Senior Portfolio Manager
973-549-4051

Chad Morganlander
Senior Portfolio Manager
973-549-4052

Matthew Battipaglia
Portfolio Manager
973-549-4047

Steve Lerit, CFA
Client Portfolio Manager
973-549-4028

Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income
415-364-2635

Rick Marrone
Senior Portfolio Manager
Municipal Fixed Income
415-364-2917

Daniel Urbanowicz
Senior Portfolio Manager
Municipal Fixed Income
973-549-4335

Suzanne Ashley
Internal Relationship Manager
973-549-4168

Eric Needham
External Sales and Marketing
312-771-6010

Disclosures

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. 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.

All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance, and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.

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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