Enhancing mid-cap portfolio performance: a dividend-oriented approach

 
 
DIVIDEND-PAYING STOCKS appear particularly attractive to us in 2010 — and prudent mid-cap investment managers can employ them as an element of a broader growth strategy.
 
A viewpoint from Kim Scott, Portfolio Manager, Ivy Mid Cap Growth Fund
 
Following the worst financial crisis since the 1930s, the U.S. economic recovery is underway and gaining steady momentum. Government, businesses and investors working to rebuild their balance sheets have created a market landscape in which dividend-paying stocks appear attractive, providing a potential means of enhancing returns as part of a broader growth investment strategy.
 
Consider: 
  • Dividend payers have a history of outperformance in post-recessionary environments. And they are particularly appealing in the current post-recessionary period due to the historically low yields available on fixed-income investments.
  • Dividend-paying stocks have produced nearly half of the stock market’s total return since 1926.1 They fare well in most market environments, providing a critical component to total return and offering downside protection in periods of market turbulence.
  • Long centralized among firms with large market capitalizations, dividend-paying opportunities currently are pronounced at the midcap space, where dividend-paying firms have grown in number.
  • Market conditions are ripe for investors aware of this trend. In the current market climate, implementing investments in dividend-paying companies as part of a broader growth strategy may provide an opportunity for mid-cap investors to enhance their returns.
 Given the current economic and equity market backdrop, dividend-yield based strategies appear well-positioned to succeed in coming months. And perhaps at no other time have those opportunities been as numerous as they are now in the mid-cap space. This paper will investigate the investment opportunity that mid-cap dividend-paying companies currently offer and examine why investors should include them in their asset allocation mix. It will illustrate historical performance of dividend-payers in post-recession environments, underscore how dividend-payers provide an opportunity for sound returns in a low interest-rate environment and highlight the rising number of mid-cap companies that pay dividends.
 
Why dividends, why mid caps, why now
 
Long a pillar of quality and stability in the U.S. equity market, dividend-paying firms have been valued for their balance-sheet strength, proven business models and fundamental strength. Firms regularly pay dividends out of their operating cash flow, a reliable indicator of a company’s underlying health — even more so than earnings. In effect, the market considers companies that consistently pay dividends as strong and positive about their prospects.
 
The longstanding perception of dividend-paying firms is that they’re large, mature, often slow- or non-growing companies with enormous balance sheets. But increasingly, mid-cap companies — firms with market capitalizations of roughly $1-15 billion that traditionally have better growth prospects than many of their large-cap market rivals —are paying dividends, and many actually have increased their payouts in recent months. Higher profits, corporate cost cutting and debt reduction on the part of many companies during the recession has many firms, including mid-cap companies, sitting on large amounts of cash that they may choose to distribute to shareholders.
 
Mid-cap companies paying dividends are additionally attractive in the current uncertain and low bond-yield environment. Based on historical evidence and the current environment, mid-cap portfolio managers in 2010 may benefit from a greater focus on investments in dividend-paying stocks as an element of a broader growth strategy.
 
High-dividend payers outperform coming out of recessions
 
Dividends have contributed nearly half the stock market’s total return from 1926 through 2009. In addition to providing a steady source of income, dividends also play an important role in periods of volatility. While price returns can be either positive or negative, dividend incomes are by definition positive, meaning they provide a cushion during negative equity markets.
 
The case for owning dividend-payers becomes even more persuasive in the current market environment. While dividends have enhanced total returns through a variety of market conditions, their contribution in post-recessionary environments has been both pronounced and consistent. Historically, high-yield dividend payers on average have outperformed low- and non-dividend paying stocks in post-recession environments. They’re particularly attractive in periods when yields on fixed-income securities are low, as they are now. Compared with bonds, dividend payers may produce a greater total return because capital appreciation opportunities inherent in equities traditionally have proved superior to those with fixed-income securities.
 
Again, history shows us that over time, income has attributed almost as much as capital gains to total equity returns. During periods of volatility or market uncertainty, dividends are more likely to contribute to returns than capital appreciation. What’s less known or understood is the historical outperformance of dividend-paying stocks coming out of a recession. The facts are compelling: 
  • Dating to 1968, the lowest quartile of dividend-paying stocks (those paying the lowest dividend, including non-dividend payers) in the S&P 500 has outperformed the highest quartile of dividend-paying stock in the index by an annualized average of 12.6 percent to 9.8 percent.2
  • However, between 1968 and 2009, the United States experienced six recessions.3 In the calendar year after those recessionary periods ended (not including the 2008-09 recession), the highest quartile of dividend-paying stocks returned, on average, 11.5 percent, far outpacing the 7.2 percent return recorded by the lowest quartile.
  • In addition, in five of the six post-recessionary years since 1968, the highest quartile of dividend-paying stocks outperformed the lowest quartile.4

 
This year, 2010, fits the classic description of a post-recessionary calendar year: U.S. gross-domestic product (GDP) began increasing in the third quarter of 2009 after declining four consecutive quarters, and the economy has grown steadily since then.5
 
Greed and fear
 
Investor behavior following periods of poor market performance historically has been characterized by loss aversion — the disparity between the strong aversion to losses relative to a reference point and the weaker desire for gains of equivalent magnitude. In other words, the angst or regret that an investor experiences over, say, a 2 percent decline in an investment is disproportionate in magnitude to the pleasure he or she experiences following a 2 percent gain. Applying this theory to the current market environment suggests that investors who have turned to fixed-income investments and shied away from riskier equity investments during the dramatic global economic downturn may prefer the relative safety and comfort of dividend-paying stocks as they cautiously move back into equities.
 
So are investors ready to return to the equity markets in a more pronounced fashion? A more meaningful question might be this: Can investment asset flows into fixed-income funds continue at the pace they occurred in 2009? Flows into domestic fixed-income funds totaled $363.8 million last year, compared with outflows of $17.8 million in domestic equity funds.6 Most of the cash that flowed into fixed-income funds came directly from money market funds, in which investors had sought safety during the tumult of the 2008 financial crisis. But if investors’ acceptance or tolerance for risk steadily increases in 2010, equity funds could see flows increase.
 
Investment flows in 2009 suggest that investors switched from money market funds to fixed-income funds to increase their investment yield while retaining relative safety. If those investors seek higher returns but don’t want to forfeit yield, they may pick dividend-paying stocks over non- and low-dividend payers as they wade back into the equity market in 2010. Meanwhile, U.S. nonfinancial companies have nearly $1 trillion in liquid assets.7 While the bulk of that is in marketable securities, hundreds of billions in cash is available that could be paid out in dividends. Standard & Poor’s has predicted a surge in dividend increases in the third quarter of this year and forecasts increases for the entire year in the S&P 500 of 5.6 percent, compared with 21 percent decrease in 2009.8 (The S&P 500 includes considerable exposure to mid-cap companies; currently, 202 firms in the index — 40 percent — also appear in the Russell Mid Cap Index.)
 
Low interest rates heighten appeal of dividend stocks
 
Current low interest rates make dividend-paying stocks appear even more attractive, particularly because rates in this post-recessionary environment9 are historically low.
 
INTEREST RATES IN POST-RECESSION CALENDAR YEARS
 
 
Fed Funds
10-Year Treasury
1971
3.50 – 5.50%
5.38 – 6.95%
1976
4.75 – 5.875%
6.80 – 8.00%
1981
12.00 – 20.00%
12.11 – 15.84%
1983
8.5 – 9.625%
10.12 – 12.20%
1992
3.00 – 4.00%
6.23 – 7.71%
2002
1.25 – 1.50%
3.57 – 5.22%
2010*
0.25%
3.54 – 3.93%
*Through 3/31/2010
 
In the early 1980s, investors seeking yield could tap the relative safety of government securities and other fixed-income instruments. That is not the case in the current market environment. Current rates on short-term investments are not keeping pace with inflation, as rates on 2-year notes or shorter-term instruments are actually negative on an inflation-adjusted basis. As of March 31, 2010, 2-year notes were yielding just 1.04 percent, and even 10-year notes, paying 3.84 percent, don’t offer much inflation-adjusted yield considering that annual U.S. inflation has averaged 3.4 percent since 1913.10 Historically low bond yields and related market variables magnify the opportunity in favor of dividend payers, and investors are finding few other options available that offer dependable income.
 
Mid-cap dividend opportunities
 
Once thought of as strictly a large-cap feature, dividends now are increasingly found further down the capitalization range, thanks in part to the market environment of the last two years. The manner in which most firms navigated the recession — reducing workforce, slashing costs and reducing debt — has left many firms with cash-heavy balance sheets as the economy moves toward recovery. That applies to small- and mid-cap companies as well as large-cap firms.
 
In terms of mid-cap dividend payers, think of them as the “new normal.” Within the 771-stock Russell Mid Cap Index, dividend increases have outpaced dividend decreases by more than a 2-to-1 ratio since the market bottomed in March 2009, as 309 companies in the index — representing 40 percent of the index — have announced dividend increases. During that period, just 145 have cut dividends.11
 
Note that almost six of every 10 stocks in the Russell Mid Cap Index now pay a dividend, with the breakdown by yield as follows:
 
 
Dividend payers historically have been “mature” companies — typically large-cap banks and other behemoth financial firms deemed stodgy and slow-growing, if growing at all. But, as the chart below shows, there now are healthy and still-growing mid-cap dividend payers in all market sectors and industries, with significant concentrations currently found in consumer discretionary, industrials and materials.
 

 
Russell Mid Cap Index Dividend Payers by sector (as of March 22, 2010)12
 
Crystallizing the case for mid-cap dividend payers
 
Mid-cap investment managers can take advantage of any post-recessionary benefit that dividend-paying stocks might offer just as much as large-cap managers can, and some attractive yields are available. Of the dividend-paying stocks within the Russell Midcap Index, 95 — or 12 percent of the index — currently pay dividend yields that exceed the 10-year Treasury yield.13
 
Many uncertainties remain for investors in the months ahead. Weakness in housing and high unemployment continue to weigh on U.S. economic recovery, while global markets face daunting sovereign debt and other financial issues. At the same time, the burgeoning economic recovery, the corporate profit growth that comes with it and the Federal Reserve’s commitment to keeping interest rates low for an extended period should provide a decent tailwind for rising equity market returns.
 
Investors concerned about the fragility of the economic recovery but also concerned about potential underexposure to equity markets might be poised to turn to the relative safety dividend-paying stocks. History shows dividend payers tend to perform well amid the conditions the U.S. economy and equity markets currently are experiencing, and mid-cap investors now have plenty of dividend-paying options from which to choose. By focusing increased attention on dividend-paying stocks as an element of a broader growth strategy, mid-cap investors may avail themselves the opportunity to enhance portfolio returns in 2010, or as long as favorable market conditions persist.
 
SOURCES
 
  1. Ibbotson Associates
  2. Citi Investment Research and Analysis
  3. As defined by the National Bureau of Economic Research (NBER)
  4. Citi Investment Research and Analysis: 1971, 1976, 1981, 1983, 1992 and 2002
  5. The widely accepted definition of a recession is two-plus straight quarters of decline in gross domestic product (GDP). NBER typically issues its official declaration of the end of a recession six to 12 months after it has ended.
  6. Financial Research Corp. (FRC)
  7. “Why You Should Get a Bigger Slice of Earnings,” The Wall Street Journal, March 13-14, 2010
  8. “Dividends Take to the Comeback Trail,” The Wall Street Journal, March 22, 2010
  9. Federal Reserve Bank of New York
  10. Bureau of Labor Statistics Consumer Price Index data, 1913-2009
  11. FactSet. Data as of Feb. 25, 2010. Dividend information unavailable for one index constituent
  12. FactSet. Data as of March 22, 2010
  13. As of March 31, 2010
 
 
Kimberly A. Scott, CFA
Ms. Scott is a senior vice president and portfolio manager with Ivy Investment Management Co. (IIMCO) and has served as portfolio manager of Ivy Mid Cap Growth Fund and Waddell & Reed Advisors New Concepts Fund since February 2001. Prior to joining Waddell & Reed as an investment analyst in April 1999, Ms. Scott worked as an equity analyst with Bartlett & Co. in Cincinnati. She earned an M.B.A. from the University of Cincinnati in 1987 and received a B.S. in microbiology from the University of Kansas in 1982.
 
Past performance is not a guarantee of future results. The opinions expressed are those of Kimberly A. Scott and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through March 31, 2010, and are subject to change due to market conditions or other factors. Investment return and principal value will fluctuate, and it’s possible to lose money by investing. Consider all factors. Investing in mid-cap stocks may carry more risk than investing in stocks of larger more well-established companies. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. These and other risks are more fully described in the fund’s prospectus.
 
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus containing this and other information for the Ivy Funds, call your financial advisor or visit us online at www.ivyfunds.com. Please read the prospectus carefully before investing.