Three recent market reversals and what they mean for shareholder yield strategies

In equity investing, the use of growth or value labels for stocks can lead to confusion. While stocks that pay dividends to shareholders are often categorized as value stocks, the growth potential and valuation profiles of many of these income-generating stocks may make it more appropriate to apply a growth label―a categorization generally describing equities that seek to generate revenue and earnings at an above-average rate. 

Three recent market reversals and what they mean for shareholder yield strategies

Similarly, at the strategy level, the value bucket may not necessarily be a good fit for all strategies that focus on dividend payers. Some such strategies defy easy categorization, including those that seek to invest in equities that we like to call steady eddies―high-quality companies that are growing, consistently generating excess cash, and distributing that cash to shareholders. These stocks are often the market’s sweet spot for shareholder yield-oriented equity portfolios, which seek to capture dividends, share buybacks, and debt repayments—the three key sources of shareholder yield.

The distinctions between investment categorizations are attracting plenty of attention now because we believe we’ve reached an inflection point regarding performance differences as equity markets have normalized and the coronavirus pandemic has eased in most countries. We’ve seen a turnaround from much of 2020; traditional growth stocks are no longer in favor, and three distinct headwinds for steady eddies and shareholder yield approaches have recently reversed course and become tailwinds.

Some of the changes that triggered these three reversals involved longstanding trends; others were unique to 2020. Here’s a look at them and the implications that we see for shareholder yield strategies.

Reversal one—no more Fab Four

Headwind: For most of 2020, markets were led by a small group of stocks that benefited from work- and shop-from-home trends that were accelerated by the pandemic. In fact, 46% of the investment return for the MSCI World Index in 2020 came from just four stocks: Apple, Microsoft, Amazon, and Tesla.1 Each of these four either had very low dividend yields or didn’t distribute dividends at all, and their outperformance in 2020 weighed on the relative results of shareholder yield approaches for which dividend income is a key strategic component.

Tailwind: Following announcements in late 2020 of clinical trial results that showed coronavirus vaccines were highly effective, the trend of outperformance by many of the year’s top-performing stocks dissipated as the themes of easing public health restrictions and economic recovery began to take hold. Market leadership broadened, and many dividend-paying stocks were among the beneficiaries.  

Reversal two—value vs. growth

Headwind: As for the relatively small group of stocks that led the broader market in 2020, it wasn’t just that select group that outperformed in the work- and shop-from-home environment. Many growth-oriented stocks that paid little or no dividends also fared well, extending a years-long run of outperformance for growth indexes relative to value indexes. However, once the rollout of vaccines became imminent, many value stocks that had lagged earlier in the pandemic began to lead the market.

Tailwind: So far in 2021, we’ve seen a more normal environment, with market leadership broadening and investor sentiment shifting from growth to value, including many stocks in industries that had been hit particularly hard in the pandemic, such as airlines, hotels, restaurants, and theaters. This shift has been a positive one for investors focused on companies that return cash to shareholders, and those stocks that we regard as steady eddies have generally been having a good year.

Is 2021 the year when growth's long run of outperformance over value will end?

Relative cumulative performance gap (%) of the MSCI World Growth Index versus the MSCI World Value Index, January 2006 through April 2021

Is 2021 the year when growth's long run of outperformance over value will end?

Note: shaded area indicates 2021.

Source: Morningstar, Inc., May 2021. The MSCI World Growth Index tracks the performance of large- and mid-cap stocks exhibiting overall growth style characteristics across 23 developed-market countries. The MSCI World Value Index tracks the performance of large- and mid-cap stocks exhibiting overall value style characteristics across 23 developed-market countries. It is not possible to invest directly in an index. Past performance does not guarantee future results.

 

Reversal three—dividend yields

Headwind: In analyzing 2020 market returns by factor, our analysis shows that stocks with above-average volatility relative to the broader market outperformed. This was a headwind for many shareholder yield strategies, which tend to focus on stocks with below-average volatility—a by-product of many of these stocks’ established histories of rising dividend payments. While more volatile stocks outperformed, factors such as profitability and dividend yield lagged.

Tailwind: So far in 2021, the profitability and dividend yield factors appear to be outperforming. This has been a positive trend for companies that tend to be consistently profitable and return excess cash to shareholders—the types of firms that shareholder yield strategies target.

Factor performance leadership shifted in early 2021

Relative cumulative performance gap (%) of the MSCI World Growth Index versus the MSCI World Value Index, January 2006 through April 2021

Factor performance leadership shifted in early 2021

 

Source: FactSet Research Systems Inc., May 2021. The Axioma World Risk model for the dividend yield factor measures the ratio of sum of dividends paid (excluding non-recurring, special dividends) over the most recent year to average market capitalization; the model for the profitability factor measures a linear combination of the return on equity, return on assets, cash flow to assets, cash flow to income, gross margin, and sales to asset descriptors; and the model for the volatility factor measures the six-month average of absolute returns over crosssectional standard deviation. Past performance does not guarantee future results.

 

From short-term shifts to sustainable trends

Looking ahead, we believe that these newly generated tailwinds are likely to persist for some time. Our outlook stems in part from two trends: the potential for rising inflation and higher interest rates, and positive momentum for dividends and share buybacks.

As to the first trend, amid a recent rise in inflation, rates recently bounced back from 2020’s extremely low levels, although they’re still quite low, historically speaking. Today’s low yields are one reason that we believe dividend-oriented equity strategies may hold appeal for many income-seeking investors, as many stocks currently pay dividend yields that are substantially higher than yields from government bonds.

However, it’s important to recognize that not all income-generating stocks are the same. If a company isn’t growing, and its dividend isn’t growing (i.e., the income is fixed), then a rise in interest rates could diminish its attractiveness. However, a company that can grow its cash flows and its dividend is nothing like a fixed-coupon bond. In fact, a growing dividend could provide a hedge against inflation.

A transition to shareholder yield

As for dividends and share buybacks, we’ve recently seen positive trends that we expect are likely to continue. While the pandemic and a global recession made 2020 a particularly challenging year for dividend investors, we believe the stage is set in 2021 for a broad recovery in earnings and cash flows. These recoveries are likely to flow through to shareholder distributions: dividends, share buybacks, and debt reduction.

Our outlook stems in part from the fact that governments across the globe have been ramping up fiscal stimulus while also maintaining or expanding accommodative monetary policies—a powerful combination. In the United States, the potential enactment of a proposed infrastructure bill would add fuel to this fire.

In addition, in the handful of industries where dividends were suppressed in 2020 by regulators or held back by political pressure, they’ve recently been returning. Many companies that were told to suspend dividends or hold them flat—including many banks and insurance companies—have recently reinstated or raised them, and companies that paused share repurchase programs have been resuming them. Overall, we believe that 2021 is likely to be especially favorable for dividend growth and distributions to shareholders.

 

 

1 FactSet Research Systems Inc., January 2021.