“Stocks that can boost dividends during periods of high inflation may outperform.” Fidelity Viewpoints

Key takeaways according to Fidelity Viewpoints

• Dividends aren’t just nice to have, they’re essential to the stock market’s return—accounting for approximately 40% of overall stock market returns since 1930.
• During periods of high inflation, stocks that increased their dividends the most considerably outperformed the broad market, on average, according to Fidelity’s sector strategist, Denise Chisholm.
• Dividend-paying stocks’ regular, scheduled payments also may help to reduce the volatility of a stock’s total return.

The economy is gradually recovering from its pandemic-related slowdown and shutdowns, and inflation has hit its highest rate in 39 years. People are emerging from the pandemic and are spending money they saved or money they’re getting from the government. Thus, a combination of soaring pent-up consumer demand and persistent supply chain disruptions has tarnished an otherwise robust economic recovery.

The Bureau of Labor Statistics said the Consumer Price Index of food, energy, goods and services rose by 0.8 percent in November, pushing annual inflation above 6.8 percent. The level is the highest since 1982 and it also marked the sixth consecutive month in which annual inflation rates have exceeded 5 percent.

Currently, approximately 70 percent of Americans rate the economy negatively, with nearly half of Americans blaming Biden for inflation, according to a recent Washington Post-ABC poll.

This combination of economic challenges and consumer worries may make this an especially good time to consider investing in stocks that pay consistent dividends.

A few important things for investors to know about dividend stocks:

• Dividend payouts typically happen quarterly, although there are a few companies that payout monthly.
• Many high-quality companies routinely raise their dividend payouts, helping hedge against inflation.
• A stock’s dividend yield moves in the opposite direction of its stock price, all else being equal, so a high yielding stock may be reason for caution.

Fidelity research finds that dividend payments have accounted for approximately 40% of the overall stock market’s return since 1930. What’s more, dividends have propped up returns when stock prices struggle.

Dividends account for about 40% of total stock market return over time

US stock returns by decade (1930–2020). Over various decades, dividends have remained a fairly steady component of stocks’ total returns amid more highly volatile stock prices. Past performance is no guarantee of future results. Source: Fidelity Investments and Morningstar, as of 12/31/2020.

To invest successfully in dividend stocks, one of the keys is finding companies with strong balance sheets and with secure payouts that can grow consistently over the long haul. Moreover, it’s important to understand the concept of dividend yield, which investors use to gauge how much dividend income their investment will produce.

Investing in dividend stocks

When selecting dividend stocks, it’s important to keep dividend quality in mind. A quality dividend payout can grow over time and potentially be sustained during economic downturns. It’s the primary reason investors must not focus solely on yield.

Steve Goddard, founder and chief investment officer of Barclay, prefers companies with high returns on capital and strong balance sheets. “High return-on-capital companies usually by definition will generate a lot more free cash flow than the average company would,” he says. And cash flow is what pays the dividend.

Although overall dividend health has improved markedly since 2020 and looks good heading into 2022, it’s equally important to check a company’s dividend policy statement so you know how much to expect in payment and when to expect it. Dividend yield is a stock’s annual dividend expressed as a percentage of its price.

It’s crucial to recognize that a stock’s price and its dividend yield move in opposite directions, as long as the dollar amount of the dividend doesn’t change. Investing in the highest-yielding shares can lead to trouble, notably dividend cuts or suspensions and big capital losses

This means a high dividend yield may be a red flag of a problem with the underlying company. For example, a stock’s yield may be high because business problems are weighing down the company’s share price. In that case, the company’s challenges may even cause it to stop or reduce its dividend payments. And before that happens, investors are likely to sell off the stock.

Fidelity Investments’ research has found that stocks that reduce or eliminate their dividends historically have underperformed the market by 20% to 25% during the year leading up to the cut.

Also consider the company’s payout ratio—the percent of its net income or free cash flow it pays in dividends. Low is usually good: A low ratio suggests the company may be able to sustain and possibly boost its payments in the future.

“As a rule of thumb, no matter what the payout ratio is, it is always important to stress test a company’s payout ratio at all points in the business cycle in order to carefully judge whether it will be able to maintain or increase its dividend,” says Adam Kramer, portfolio manager for the Fidelity Multi-Asset Income Fund.

“It all depends on the stability of the cash flows of a company, so it’s more about that than the level of payout. You want to test the company’s ability to pay and increase the dividend under different scenarios. In general, when the payout ratio is more than 50%, it’s a good reminder to always stress test that ratio,” Kramer explains.

Be sure to diversify as you build a portfolio of dividend-paying stocks. To help manage risk, invest across sectors rather than concentrating on those with relatively high dividends, such as consumer staples and energy.

References:

1. https://www.fidelity.com/learning-center/trading-investing/inflation-and-dividend-stocks
2. https://www.barrons.com/articles/quality-dividend-stocks-51639134001
3. https://news.yahoo.com/inflation-pinch-challenges-biden-agenda-200620196.html

Past performance and dividend rates are historical and do not guarantee future results. Diversification and asset allocation do not ensure a profit or guarantee against loss. Investing in stock involves risks, including the loss of principal.