Using Dividends to Identify Quality Value Ideas

Not all value stocks are dividend payers and not all dividend equities are value stocks, but as advisors know, there are often overt ties between dividend and value names.

Combining dividends and value has other benefits, some of which are on clear display as dividend-paying and value equities are performing significantly less worse than non-payout and growth stocks as well as basic broad market strategies.

In the first quarter, “nearly every US company in the Index (99%) increased their payments or held them steady, as dividends continued to be a reliable source of income growth for shareholders,” according to a statement issued by Janus Henderson.

That is to say it’s an ideal time for advisors to discuss dividend strategies with clients,  particularly more payout growth is expected this year. Moreover, dividends are excellent avenues for avoiding value traps – the stocks that often seduce clients with bargain bin valuations, but are usually fundamentally flawed.

Avoiding Value Traps

Many clients aren’t familiar with the term value trap, but it’s easy for advisors to impart this wisdom upon them. Essentially, the issue is that not all cheap stocks are good stocks and many are cheap for various reasons, none of which are positive. Said another way, not all inexpensive stocks offer value.

Fortunately, dividends add a layer of defense to the value proposition. Part of the reason for that is that defensive sectors – namely consumer staples and utilities – have compelling payout reputations. This year, this thesis is playing out in real time to the benefit of clients.

“This ‘defensive value’ nature of high dividends can be seen from the down-capture ratio of just 59% for a value portfolio sorted by dividend yield. A portfolio sorted on book-to-price (the most traditional academic measure of value) has a down-capture rate of 100%,” notes WisdomTree’s Matt Wagner.

As such, high dividend ETFs have hauled in $25 billion in new assets year-to-date. That’s a tidy sum and it doesn’t even include the inflows to dividend growth ETFs, which have been impressive in their own right. A figure as high as $25 billion indicates advisors are putting client money to work in high dividend ETFs. That’s proving to be a fruitful, less bad way of allocating client capital.

“Most of the pain in U.S. equities this year has been felt by non-dividend payers relative to dividend payers. Going forward, should we see material weakness in the economy, investors may begin to focus on the safety of dividend payouts,” adds Wagner.

Yes, Safety Matters

Perhaps too often, clients perceive dividends as “free” or “riskless” money. Advisors know better and that’s part of what makes the dividend conversation a stimulating one.

Additionally, assessing the current viability of a payout and its potential steady long-term growth can provide clients with a window into credible value opportunities.

“Using dividends as a measure of value has a key advantage over measures like earnings or book value in times of uncertainty—a dividend is an unambiguous measure of value that is insulated from aggressive accounting practices,” says Wagner.

Fortunately, using dividends as identifiers of value traps can be put into practice rather efficiently – a plus for time-strapped advisors.

An emphasis on quality and momentum “determined by static observations and trends of return on equity (ROE), return on assets (ROA), gross profits over assets and cash flows over assets. Scores are calculated within industry groups and determined by stocks’ risk-adjusted total returns over historical periods (6 and 12 months),” concludes Wagner can get the job done.

Related: 60/40 Outlook Not All Doom and Gloom