One part of the equity market that has benefited from a so-called flight to safety during this period of volatility has been the dividend stocks.

For example, the S&P 500 Dividend Aristocrats index has outperformed the broader index by nearly eight percentage points to start the year (on a total return basis). Likewise, the S&P 500 High Dividend index has surpassed the overall market by a whopping 20 percentage points.

Perhaps this is rather unsurprising, given that these stocks typically possess the qualities you would want to own during a downturn: large companies with stable cash flow and profitability, growing income streams, balance-sheet quality and often are found in more defensive sectors.

If we plot the relative strength of the Dividend Aristocrats against the S&P 500, there is a clear outperformance surge during periods of poor economic growth and/or recession. Since we expect growth to underwhelm through the rest of the year, we believe there are still opportunities to be found for investors looking to get more defensive and add exposure to the areas of the stock market offering attractive yields.

The rise in Treasury yields has eliminated the dividend premium of the S&P 500, but that does not mean opportunities cannot be found underneath the hood. With this in mind, we re-ran a dividend screen looking at the subsectors within the index that offer attractive yields, while also evaluating if they are safe and have a history of consistent growth and sustainable payout ratios.

Previous reports focused on subsectors offering an income stream pick-up of 100 basis points, or more, over the 10-year yield, but this approach would, admittedly, produce sparse results in the current environment. Given our call for Treasury yields to continue to come down — and the 10-year to fall below two per cent — we will expand the cut-off to include areas with dividend yields that are at, or slightly below, the current 10-year level, which will shift to a premium as Treasury rates fall further. The result shows 18 subsectors satisfy the requirements mentioned above.

Dividend growth was calculated using a three-year compound annual growth rate (CAGR) to account for pre-pandemic performance, while the historic volatility of those growth rates was used to gauge consistency. We also averaged the payout ratio of each sector using data back to 2006 as a proxy for “safety.” Finally, we added valuations (and their relative relationship to the overall S&P 500) to assess the potential for price appreciation for those seeking more than just an income stream.

As expected, the traditional high-yielding telecom services and tobacco sectors top our list, offering a yield premium of 382 and 258 basis points, respectively. Payout ratios do tend to be higher, but by being in mature industries with stable earnings profiles, management can engage in an aggressive return of capital strategy for shareholders.

We would also add the oil and gas industry to our top rankings. Despite having a smaller premium than the other two, at only 50 basis points, this could grow considerably given elevated commodity prices alongside capex discipline and a current payout ratio at only 50 per cent, meaning there is more room to give back cash to shareholders as free cash flow rises. Not to mention the strong potential for price gains, with relative valuations to the overall S&P 500 nearly eight multiple points below their historical average. It’s the same story for telecom services, by the way, for those looking to mix an income stream with capital appreciation.

After this grouping, the list of attractive opportunities shrinks considerably in our view. However, two additional options stand out: the independent power and renewables and biotech industries. To be fair, the high volatility in dividend growth will likely be off-putting to many risk-averse investors. Like everything else in financial markets, however, high risk does lead to high reward and, in this case, is accompanied by two of the fastest dividend growth rates over the past three years, at 25 per cent for independent power and renewables and 12 per cent for the biotech space. These two subsectors typically have among the lowest payout ratios on the list (providing a margin of safety for the dividend), and also come with relative valuation discounts to boot (again, meaning the potential for price gains on the stocks).

For those not comfortable taking on the higher dividend volatility of the two aforementioned industries, other options that jump out include the pharmaceutical subsector and air freight and logistics. These two areas of the market also include strong dividend growth, at nine per cent and seven per cent, respectively, with safe payout ratios and attractive P/E multiples, but come with some of the lowest dividend volatility at just two per cent and three per cent, respectively.

Ultimately, it has been a different environment for investors searching for income compared to the recent past, with rising Treasury yields providing an alternative that did not exist for many years. That said, dividend stocks have been a beneficiary of this risk-off period due to the many defensive qualities they possess, and ideas can still be found when scratching below the surface, such as in the diversified telecom, tobacco and oil and gas subsectors.

Additionally, for higher-risk investors, the independent power and renewables and biotech groups offer some of the fastest-growing income streams (though this comes with higher volatility) and present as interesting opportunities further down in our screen (pharmaceuticals and air freight and logistics as well, but offer more traditional yield growth and stability for the more risk-averse).

Furthermore, if expectations of a decline in Treasury yields from current levels are correct, this will act as a further tailwind to these names by increasing the relative attractiveness of their income streams, bringing fund-flows and price appreciation along with it.

Photo by John Guccione www.advergroup.com

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