For investors seeking dividends, it’s essential to opt for the healthier portion of the income spectrum, bypassing the immediate allure of high-yielding stocks.
While those high-yielding options may seem tempting, especially with dividend yields surpassing 4.8%, they could be the ones most impacted if the Federal Reserve decides to cut interest rates. In a scenario where investors struggle to attain a 5% return in T-bills, a dividend yield as high as 9.1%, as seen in shares of Altria, might appear increasingly appealing. However, it’s crucial to exercise caution and refrain from indulging in high-yielding stocks at this time. The current economic landscape remains robust, with inflation levels surpassing expectations, potentially deterring the Fed from implementing significant rate cuts, if any. The market currently anticipates three rate cuts in 2024, a significant decrease from the initial projection of six cuts at the beginning of the year.
Despite their seemingly attractive yields, high-dividend stocks have not been performing exceptionally well. Over the past 12 months, the top 20% of dividend yielders in the S&P 500 have yielded only about 7% for investors, significantly trailing behind the overall index by approximately 29 percentage points. Consequently, it’s advisable to consider stocks with “second quintile” yields—those offering higher yields than 60% of the stocks in a given universe but lower than the top 20%.
Investors have valid reasons to look beyond the highest-yielding stocks. The top quintile of high-yielders in the S&P 500 often carries substantial debt burdens, with an average debt-to-Ebitda ratio of 3.7 times, significantly higher than the second and third quintiles. Additionally, these top-yielding stocks typically allocate nearly 90% of their net income as dividends and are projected to achieve modest earnings growth of approximately 5% annually in the near future. Conversely, the remainder of S&P 500 dividend-paying companies distribute about 40% of net income as dividends and are expected to experience earnings growth at nearly twice the rate.
Given these considerations, Chris Senyek, Chief Investment Strategist at Wolfe Research, has begun to favor consumer staples following a period of lackluster performance. While staples stocks in the S&P 500 have underperformed the broader index by approximately 26 percentage points over the past 12 months, Senyek identifies five companies meeting his second-quintile criteria: General Mills, Coca-Cola, PepsiCo, Keurig Dr Pepper, and Molson Coors Beverage. Despite these stocks delivering negative returns of approximately 12% over the past year, their financial metrics remain robust, boasting an average yield of about 3.1%—higher than the S&P 500 average of 2.4%. Moreover, they pay out approximately 57% of net income as dividends and are projected to achieve earnings growth of approximately 9% annually over the coming years.
Dennis DeBusschere, chief market strategist at 22V Research, echoes the sentiment of focusing on companies capable of raising their dividends amid the current higher interest rate environment. For his clients, he has compiled a list of 50 such companies with sustainable dividend growth potential, including Snap-On, Quest Diagnostics, Tapestry, Starbucks, and Air Products & Chemicals. These five companies boast an average yield of about 2.6%, pay out less than half of their net income as dividends, and are projected to achieve earnings growth of approximately 8% annually over the coming years. Additionally, they fall within the second quintile of dividend payers.
DeBusschere emphasizes the importance of investing in companies with the capacity to increase dividends. He suggests favoring higher-quality stocks with lower dividend yields and stronger financial metrics over those with juicier dividend payouts. According to DeBusschere, the highest-yielding stocks may not necessarily be the most advantageous choice in the long run, making it prudent to prioritize sustainable dividend growth potential in portfolio allocation decisions.