A Case for Dividend Stocks
An investor outlines what she sees as the advantages of dividend income over bonds.
Jenny Harrington, a portfolio manager at Gilman Hill Asset Management in New Canaan, Conn., as well as the boutique investment firm’s CEO, spends much of her time analyzing income, specifically from dividends. The firm’s equity income strategy aims for a dividend yield of at least 5%, along with capital appreciation. As of Sept. 30, that strategy’s annualized composite return, net of fees, was 6.42% since its inception in October of 2006. Its yield was 6.6%. Most of the portfolio’s holdings are stocks. The firm manages about $800 million of assets.
Appearing regularly on cable business news platform CNBC, Harrington enjoys a good debate about stocks, dividends or the market. Income Matters Today interviewed Harrington recently by phone. This is an edited version of that conversation.
IMT: What’s important to consider from 30,000 feet when it comes to dividend stock investing?
Jenny Harrington: Two things: the sustainability of income and then after-tax and after-inflation returns. Sustainability of income was always important. But after-tax income is a really important consideration that a lot of people miss. That’s because they forget that taxable bonds have an ordinary income tax rate. Dividends have a favorable tax rate, which is a really, really big difference in what you're putting in your pocket at the end of the month.
After inflation is also a big deal. Think about real yields versus nominal yields. If you're getting 4.6% on a 10- year Treasury, but inflation is 3% or 4%, what you're really getting is 1.6% or maybe 2.1%, depending on the actual inflation number. People don’t focus on that enough.
The other thing to consider is that dividend income is growing over time because most companies raise their dividends every year. But when you lock in a 4.6% yield to maturity on a bond, that's all you're getting. That income isn’t growing.
Bond yields have surged lately, and you can earn 5%-plus on a one-month T bill. Has that impacted how your clients are thinking about income?
They're clearly thinking about their sources of income differently. I have worked with a woman in Maryland, who runs a family office, for about 15 years on asset allocation for clients. For the first five years that we worked together, there was always a conversation about what part of the portfolio should be in bonds. And then, for the better part of the last 10 years, to the degree that we could, we reduced our clients’ bond portfolios for years and years. And we got people to zero if that made sense. Or we took them from, say, a 40% fixed-income allocation to a 15% allocation. We knew that the risk-return equation on bonds was broken. But in the last nine months, for the first time in a decade, she and I have reintroduced the notion of “Should we allocate to bonds again.” So that part's changing. It doesn't always make sense, but it's important to have as a consideration and part of the conversation again.
And, presumably, bond valuations are much better now that rates have spiked so much. On another subject, do your clients clip their coupons, so to speak, and use that income to live on. Are they using dividend income to grow their wealth for the long haul? Or is it a combination?
It totally depends. Remember that for my clients, I'm a dividend income manager – that’s different than dividend growth – so there's a heavy income component of their portfolios. I would estimate that half of my clients use that income as a supplemental source of income for retirement or for whatever their life looks like. And half of them just need that income to psychologically be comfortable with investing in equities. Because whether you need the income or whether you just want the income when you go through a March of 2020 -- and everything's terrible, and the market’s down 35% -- when that income is just plunking into your account, month after month uninterrupted, it brings a level of emotional comfort that helps you get through the worst market periods. It’s interesting to me how many of my clients just want that income for the emotional comfort that it brings to the otherwise chaotic world of equity investing.
Most large U.S. companies continue to raise their dividends at a good clip. What do you attribute that to?
The mega-cap companies have seen their earnings growth rates slow significantly, there's less that they can do to reinvest their profits internally, and there are fewer acquisitions they can make. So, they just have tons of cash. You see companies like Apple (ticker: AAPL) and Microsoft (MSFT) -- they don't have very high dividend yields. Apple’s is about 0.5%, and Microsoft’s is 0.9%. But they're both paying out significant quantities of cash. The importance of dividends as an element of shareholder return is as strong now as it ever was.
Is there anything else that you think people overlook about income investing?
Investors in some cases think of dividend stocks as being sleepy and less volatile than the broader market. Maybe that was true once upon a time, but it’s not anymore. What we're seeing is that the dividend stocks have roughly as much standard deviation as the broader market does. As long as you know that going in -- and you are managing your own expectations -- it gives you a lot more wherewithal to be a good dividend-income investor. You should expect your income to be steady. But you also need to expect volatility in stock prices. It's very much like the broader equity market; that's what it's become. And you have to know that the gains will compound over the long term.
It’s interesting to me how many of my clients just want that income for the emotional comfort that it brings to the otherwise chaotic world of equity investing. —Jenny Harrington
Any thoughts on why dividend stocks have lagged the broader market this year?
That's an issue that people have as well -- short termism, or whatever you want to call it. In 2022, the market was down about 18%, and the dividend indexes were down about 7%. Yes, they're lagging this year. But on a net basis, they are right now doing what they should be doing, which is pumping out the income. Over the long term, these stocks will deliver nice capital appreciation with a bump on top of that from the dividends. I feel, though, that people have already forgotten that dividend stocks outperformed so significantly last year.
Where are you finding opportunities in terms of stock sectors?
Right now the bulk of the opportunities when you screen for stocks are in retail and financials. If you look through the health care sector, or even the energy sector, the opportunities are dramatically diminished. There are few opportunities besides IBM (IBM) in the technology sector. If I were really just chasing income, you would see a portfolio that is all retail and financial stocks.
But having a portfolio that's well balanced by sector and industry is our attempt to generate an income stream that holds up, whatever macroeconomic environment comes our way. We have almost no utilities, which have badly lagged the broader market, but we are looking at that sector now. The construction of the portfolio is intended to say, “We're not sure what macro environment will be delivered to us so here's a collection of stocks.” Some of those stocks will protect us if there’s a worse outcome than expected.
Let’s move on and hear about a few of your holdings. Are you finding opportunities in larger-cap stocks?
In the last six months, we've moved into higher-quality companies, but they're not necessarily larger cap. We added Whirlpool (WHR), which has a market cap of about $7 billion. We added standard Stanley Black & Decker (SWK), which has a market cap of about $12 billion and is a Dividend Aristocrat. We rarely get to buy Dividend Aristocrats.
(Editor’s note: The constituents of the S&P 500 Dividend Aristocrats Index have paid out a higher dividend for at least 25 straight years.)
We also added Crown Castle (CCI), which has a market cap of around $39 billion. All three of these companies have incredibly long and solid track records of paying and raising their dividends.
Could you provide a little color on each of these holdings?
Crown Castle is a cell tower REIT, or real estate investment trust. The company benefited from 5G spending and it’s now enduring some curtailment of spending from its customers. But the long-term structural growth will continue, and the valuation is cheaper than it's been in many years. It recently traded at 14.3 times estimated 2024 Ebitda, or earnings before interest, taxes, depreciation and amortization. The stock’s yield was recently at close to 7%.
As for Stanley Black & Decker, it had an enormous boost to earnings during the pandemic. But the stock came under pressure, losing more than half of its value since May of 2021, as consumer demand waned and retailers destocked their inventories. We think the market is pricing in an inability for the company to recover its earnings power over the next few years, a view that’s Draconian. The stock was recently yielding about 4%.
Whirlpool, meanwhile, also had a big boost to earnings from Covid. But consumer demand fell off and retailers destocked. The stock has sold off sharply since 2021. But the company has proven to be a pretty disciplined operator, and they have cleaned up the portfolio, including the impending divestiture of most of its European, Middle East and Africa business. With a solid balance sheet and solid dividend track record, the company is capable of continuing to pay its attractive yield while earnings recover. The stock yields about 5.5%.
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