Zacks Investment Management

Regular readers may recall a few weeks ago when I interviewed our own Manish Jain about the Zacks Mid Cap Core Strategy. In that column, Manish explained to us how Mid-Cap stocks represent a sweet spot on the risk curve—they are companies that have typically been around long enough to have lengthy earnings records and management tenures, but they’re not so big that they’re always in the spotlight and subject to the forces of big institutional trades. On the other hand, they’re also not so small that they carry more business cycle risk with volatile swings in earnings.

We live in a world where it’s extremely difficult for investors to find yield (think about how little the CD at the bank or any U.S. Treasury bond will pay you). This ‘interest rate dilemma’ has left many retirees frustrated at how difficult it can be to create cash flows from an investment portfolio.

But, that’s where a dividend-focused approach can make a difference. If you could build a portfolio that had a higher yield than the 10-year or 30-year U.S. Treasury and a higher yield than the S&P 500—but with lower risk against the S&P 500—would you build it? Well, we’ve built it at Zacks Investment Management. We call it Zacks Dividend Strategy. This strategy has outperformed its benchmark since inception, with less downside volatility along the way, and is ranked in the top 2% of 943 managers in the Morningstar Large Cap Value universe (as of 6/30/16).

To give investors an inside glimpse into the strategy and an outlook for dividend stocks, here’s a transcript of my interview with Prasanth Sankar who runs this strategy alongside myself and Manish Jain who is part of our investment committee:

What are some of the reasons why investors should consider a dividend-paying strategy?

Manish:  Let me first remind readers that for purposes of producing income, a dividend-paying strategy is by no means a perfect substitute for a fixed income approach. Even though in today’s environment a dividend-paying strategy can help you obtain a higher yield out of your portfolio, it’s still an equity strategy, meaning it is subject to a higher degree of price volatility than a fixed income approach. So, an investor has to be comfortable with the equity exposure.

Assuming that’s the case, there are three main reasons why a dividend-paying approach can be useful for an investor seeking growth and income:

• Total Return and Income – here’s an interesting fact many readers may not know: from the end of June 1986 to the end of June 2016 [so looking at a 30-year period], the S&P 500 returned 736.73% on a price appreciation basis. If you look at the same period’s total returns, however, meaning that you’re factoring-in dividend payments, the S&P 500 returned 1,550.01%. It’s easy to see here that dividends make a huge difference! That additional return is created by companies paying shareholders cash for holding shares.
• Cushion Downside Volatility – piggybacking on that last point, as that cash accumulates, it inherently creates a cushion to downside volatility as it occurs. In other words, as you build a cash balance in your portfolio from dividend payments, it decreases your portfolio’s total exposure to equities, to a small but relevant degree. That can help you feel less of the pinch from the market’s natural drawdowns.
• Foreign Exposure – many of the most consistent dividend payers are large cap or even mega cap stocks, and those stocks almost unanimously operate in foreign markets. Owning these multinational companies can mean giving your portfolio some international exposure, without having to buy companies domiciled in other countries.

What criteria do you use when choosing dividend-paying stocks for the portfolio?

Prasanth: We start off by examining all 650 stocks in the Russell 1000 Value Index, and then we use what we call a “3 Factor Alpha Model” to assess each one. Think of it like three pronged approach:

• Short Interest: dividend-paying stocks with low levels of short interest have demonstrated lower levels of volatility over time—an attractive feature. What we mean by “short interest” is the degree of ‘shorts’ that market participants have on the stock. In other words, how bearish investors are on the stock.
• Free Cash Flow: looking at a company’s free cash flow from operations will help give an indication if its dividends are sustainable, and if they make sense.
• Dividend Yield: When looking at companies, we want to see a sustained dividend yield of at least 1.5%, but it starts to look a bit concerning if it gets up to 8% or higher. In those cases, the free cash flow may be getting stretched just to keep shareholders happy, instead of investing in the company’s growth.

Our model takes inputs on those three factors, and with an algorithm gives it a score of 1 to 99, and then our proprietary optimizer kicks-in and will look at the correlation between stocks to find the optimal mix.

Investors might note that “yield-seekers” have been flocking to defensive categories of stocks (Healthcare, Consumer Staples, Utilities), and that’s also where you find a lot of the steady dividend payers. Is the category now too expensive?

Prasanth: It’s true that we’re seeing more capital inflows into dividend-paying stocks and defensive categories, but the same can be said of basically every risk asset in the U.S. With interest rates near zero in just about every developed country, investors seeking yield are basically left without a choice but to flock to risk assets to achieve the total return they’re after. Dividend-paying stocks are of course a favorable target for these yield-seeking investors, and valuations are rising. But when you think about it, as long as the equity yield stays well above the risk free rate (which we expect will last for at least a couple of years), investors are likely to continue making this rotation. If global growth continues expanding—even if at a very modest pace—there will be capital out there looking for a home, and the current interest rate environment makes stocks a good place for it.

Bottom Line for Investors

As Manish and Prasanth mentioned earlier in the interview, an investor shouldn’t view dividend-paying stocks as a “plug and play” substitution for a U.S. Treasury or other fixed income product. One is equity and the other is debt, and they’re not the same thing. Equities inherently have a higher risk of loss and are likely to endure greater degrees of price volatility along the way.

That being said, for investors seeking growth and income and who are also comfortable investing in stocks, a dividend stock approach could be a solid solution for your portfolio. As of the end of the second quarter, the Zacks Dividend Strategy has a substantially higher yield than the S&P 500, with lower volatility and low turnover.

Disclosure