How a dividend investing strategy builds resilience

DIVIDEND investing strategies are known to generate attractive long-term returns, particularly on a risk-adjusted basis. Such strategies offer defensive advantages, including less downside volatility in weaker market conditions on average.

However, the specific conditions of any given economic cycle also matter greatly, as does the type of dividend strategy being pursued.

In global equities, a dividend investing strategy focused on companies that consistently grow their dividends can offer a powerful combination of growth with resilience, which may be particularly suitable in the prevailing global environment of slowing growth, elevated inflation and higher interest rates.

Superior long-term returns

There is substantial evidence from across different equity markets that dividend-orientated investing outperforms the broader market over the long run. Over the last 20 years, no-change dividend-paying global companies – those that have just maintained their dividends without raising or cutting them – have comfortably outperformed broader global companies, as represented by the MSCI ACWI index.

However, the stand-out performance has come from companies that have initiated or consistently grown their dividend payments. This segment’s annual return over the last 20 years is nearly triple that of the broad global equity index.

Further indicating the importance of dividend directionality, history shows a marked underperformance in the returns of companies that have cut or eliminated their dividend payments.

Lower volatility

The other main attraction of dividend investing comes from the risk perspective – namely, lower volatility, which has contributed to historically attractive risk-adjusted returns over the long run.

Within global equities, the annual return volatility of “dividend-growers and initiators” is lower than “dividend-cutters and eliminators”, and considerably lower than “no-change dividend-paying” companies. Relative to broader global equities too – such as the MSCI ACWI index – over the last 20 years, the return volatility of dividend-growers and initiators has also been slightly lower, contributing to better risk-adjusted returns.

While the side-by-side depiction of annual returns versus annual volatility is useful, a more precise and comparative measure of returns versus risk is available from a Sharpe ratio perspective.

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On this measure, the superior risk-adjusted returns of the dividend-growers and initiators segment is striking.

Risk advantage

A company’s ability to pay dividends regularly and to grow them is widely regarded as an indicator of reliable earnings quality and growth.

The risk advantage of dividend strategies may also be linked to behavioural investing. In more challenging economic and market conditions, equity investors tend to prefer the increased certainty of dividend payments which are inherently less risky and volatile than capital gains. Dividend cashflows also provide a valuable cushion against potential capital weakness.

In terms of company behaviour, there is usually strong aversion to cutting dividends because of the potential negative signalling effects. This helps to explain the considerably lower year-to-year volatility in dividends payments compared to corporate profits.

Lower drawdowns and inflation protection

The above mix of behavioural factors helps to explain the frequently observed pattern of outperformance of dividend strategies in down markets.

In a rising market, dividend growers may capture relatively less of the upside compared to broader global equities. But the drawdown in a falling market of dividend initiators and growers was less than half of that of global equities over the last 20 years. This segment’s lower drawdowns trump the lower upside capture, resulting in substantial outperformance over the long run.

Equity dividends offer advantages compared to income from bonds. First, albeit with more risk, equities offer greater upside potential from price appreciation.

Second, unlike with bonds that pay set interest rates, companies have the ability to increase their dividend payments over time. Hence, companies that raise dividends in inflationary environments can potentially provide inflation-hedged income opportunities.

In global equities, the abundance of dividends across key sectors means there is also ample scope for diversification.

Global equities, as represented by the MSCI ACWI Index, are especially well diversified across sectors, more so than some regional markets. This supports the case for a global approach to dividend investing.

Dividend investing today

Today’s global economic environment is for the most part characterised by high inflation, which has spurred an unprecedented pace of interest rate rises to address this. This is leading to markedly slower economic growth and an elevated risk of recession in many countries.

In this context, the surge in the risk-free interest rates implies a reduced investor preference for companies whose future growth is uncertain, and an increased preference for solid earners, high dividend payers and growers.

In the current environment of significantly higher interest rates and increased credit risk, balance sheet strength gains added importance. We believe that to execute a dividend-focused strategy, an active rather than a passive approach is better suited to identifying the totality of specific risks and opportunities.

In summary, the long-term case for a strategy focusing on dividend growth in global equities is empirically well grounded. Such an approach may appeal investors looking for global equity exposure, but with a greater degree of built-in resilience.

The writer is head of global income, abrdn