Why Dividend-Paying Stocks in 2023

Dividend and value stocks underperformed for much of the past decade as historically low interest rates pushed investors into increasingly speculative investments. However, since the beginning of 2022 both rates and future rate expectations have moved sharply higher. Typically in this environment, speculative investments become less attractive and the demand for near-term, predictable, and attractively priced cash flows increases.

We believe the threat of a recession has also contributed to the outperformance of dividend and high quality value stocks. Not only does lower growth have an adverse impact on the optimism that underpins growth-focused investing but, for dividend payers, the certainty stemming from quarterly cash payments becomes especially valuable when investors seek to reduce risk. 

As far as the sustainability of these trends, while inflation and rate increases are likely to moderate in 2023, it is unlikely the Federal Reserve will seek to reduce rates to previous levels, even if the economy enters a recession. We believe the risk of high, systemic inflation is simply too great, particularly given other macro and geopolitical factors. The recent layoffs in Silicon Valley are evidence of this shift in expectations as newly instilled capital discipline forces management teams to reconsider the “blue sky” opportunities they have been chasing. Similar to the post-internet bubble period, the outgoing tide has also begun to reveal the excesses, waste, and fraud that accumulated over the past decade. In our opinion, each of these announcements helps ground investors’ long-term expectations in fundamental reality rather than speculative fantasy. However, a transition of this magnitude takes years, not quarters, to unfold, which is a key reason why we believe dividend payers are well positioned for the decade ahead. 

There is a fundamental difference between how inflation impacts fixed income and equity income portfolios. Most fixed income investments are predicated on a contracted payment for a set period. As such, fixed income investors assume substantial inflation risk. In contrast, a high quality dividend payer can, and we believe likely will, grow its income stream over time, providing a hedge against the pernicious impact of inflation. According to Ned Davis Research, the dividends paid by S&P 500 companies have increased by 9.70% in the past year, which more than offsets even the high inflation rate in recent quarters. In fact, over the past five decades, the dividend payment of the S&P 500^® Index has increased by a 6% rate on average, well above the historical inflation rate in the United States. 

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We believe the key for a dividend investor is to successfully identify high quality companies with defensible business models and avoid those with narrow moats, excess leverage, and weak management teams. The former should be able to pass along inflation to their customers, maintain an attractive profit margin, and provide real growth in their dividend over time, even if inflation rates rise substantially. Conversely, the latter is more likely to see margins fall, valuations collapse, and their dividend reduced or even suspended. 

In 2003 and the few years that followed, even as former Fed Chairman Alan Greenspan methodically increased interest rates, dividend-paying stocks performed extremely well. According to Ned Davis Research, since 1979, dividend payers in the S&P 500 have outperformed non-payers in periods where the 10-year Treasury is rising. Additionally, it was noted that high-yielding stocks outperformed low yielding in those periods.

Ultimately, we believe the growth environment is a critical factor in the relative performance of dividend stocks. If rates are rising while growth is slowing, as they are now, we would expect that to be a good environment for dividend payers. In contrast, if economic growth is high and/or accelerating into the early stages of a tightening cycle, more typical of a late phase market expansion, we would not expect dividend stocks to lead.

One of the provisions of the recently passed Inflation Reduction Act levies a 1% excise tax on net corporate shares repurchased starting in 2023. We do not expect a material impact on either dividends or share repurchases if the levy remains at this low level. The economic truism “if you want less of something, tax it more” is still in effect; however, a 1% tax is unlikely to have more than a marginal impact.

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Nevertheless, if this levy does substantially increase over time, much like the 1% income tax first levied in 1913, companies could substantially reduce or even forgo share repurchases. In such a scenario, we expect companies would increasingly return excess capital through annual variable dividend payments, which should be a boon for income-focused investors.

We approach the question of market cap exposure from a bottom-up perspective, taking both valuation and conviction into consideration. Given the relative attractiveness of small cap valuations, new positions have tended to be smaller in cap size. However, turnover has not been significant enough to materially impact the median market cap weight of the Portfolio. Furthermore, the relative valuation of high quality small cap dividend payers is not as attractive as the broader market cap index comparisons. Thus, new opportunities have not been as robust as they might otherwise appear.

Finally, small caps tend to be more cyclical in nature, even among dividend payers, which tends to make them a bit lower in overall conviction. Depending on the environment, our appetite for this exposure will vary. The DAV team would describe our current appetite as neutral. Thus, unless something changes in the Portfolio or broader environment to shift this appetite, we would expect our overall market cap exposure to remain pretty stable.

Broadly speaking, we are seeking to leverage market volatility by selling fully valued stocks into rallies and leveraging our watchlist into weakness. The past year brought plenty of both, and we expect the same in 2023. We have further tried to ensure that new positions do not combine cyclical cash flows with elevated leverage, which should help us to navigate what promises to be a challenging year for equity markets.

While we expect volatility will remain elevated in the first half of the year as global economies continue to wrestle with higher interest rates, energy insecurity, and other challenges, absent crisis, we believe the market could take on a more positive tone in 2023 following a very tough 2022.