New World Wisdom: Winning More by Losing Less

Point of View With the Equity Dividend Fund Team

It's one of the cruel ironies of the investing world today: Investors need growth in their portfolios, if only to outpace inflation. But one of the primary vehicles for obtaining it—stocks—is subject to unnerving volatility. And just as market turbulence has many investors holed up in bonds, these traditional income workhorses are facing a dilemma of their own—anemic yields and, in many cases, no or negative returns after inflation and taxes. What's an investor to do? Portfolio managers of the BlackRock Equity Dividend Fund believe high-quality companies that pay and grow their dividends are wise choices for the "new world of investing." Here's why:

• Below-market volatility. S&P 500 dividend payers historically have outperformed non-dividend payers over time with lower volatility than the broader market.
• Lower prices for higher quality. The investor hunger for yield has the market placing a premium on the highest-yielding (and higher-risk) stocks. This affords the opportunity to increase the quality of a stock portfolio by purchasing highquality dividend payers at attractive valuations.
• Income and growth potential. Dividend stocks offer income that rivals or outstrips that of traditional fixed income options today, while also providing capital appreciation potential not available from bonds.

Why own dividend stocks today?

Despite the prevailing uncertainty and volatility in financial markets, investors still need growth in their portfolios. They also need income (a powerful wealth builder) at a time when interest rates around the world are at all-time lows. We believe the stocks of high-quality companies that can pay and grow their dividends address all of these considerations. They offer the unique trifecta of competitive income, attractive long-term growth potential and relatively low volatility compared to the broader equity market.

Why is low volatility better? Market swings can also produce some impressive upside.

Volatility offers upside as well as downside, and that can mean the potential to capitalize on some meaningful upward swings—if you happen to time it right. But markets are unpredictable, particularly in the current environment of policy uncertainty and fragile economic data, so it's a dangerous proposition. In most cases, it's the other side of volatility—the significant and erratic dips—that can be extremely destructive to long-term growth. If you look at stock performance trends over time, you'll notice losses have a bigger effect on the long-term outcome than do gains. And as the table on the following page shows, the deeper the fall, the harder it is to dig out and break even.

We'd much rather have a portfolio that is built to help soften the inherent downside of equity investing. It might mean giving up some outsized gains when markets spike up, but we believe it has the potential to result in a more favorable outcome over time—and a smoother, less nerve-wracking ride along the way. We're not timing the market, we're not taking risky bets in hopes of fleeting gain. We don't want to lead the sprint. Ultimately, we want to win the marathon by losing less along the way.

What makes dividend stocks less volatile?

Companies that can pay, sustain or grow their dividends over time tend to be healthier than those that cannot. During tough times, these companies can rely more on the strength of their balance sheets and cash reserves (accrued from operating, financing or investing activities) to maintain positive cash flow and even gain an advantage. This can ultimately provide a buffer against slowing sales or declining profit margins in a challenging environment. Because of this, these companies' stock prices tend to be more supportive when the markets aren't doing well. We appreciate this perceived protection, and it's something we strive for in our investments. We seek to construct a portfolio of companies with greater stability and consistency, and this has led to more consistent returns and income growth over time.

So you'd say all stocks are not created equal?

Precisely. Companies that pay dividends typically have better business models, stronger balance sheets and a higher degree of confidence in their growth capabilities than those that do not. While there is no guarantee that dividend-paying stocks will continue to pay dividends, these characteristics historically have helped them outperform in difficult and volatile times, such as we have experienced in recent years.

The pain of the 2008 financial crisis runs deep. But there is a real danger in staying sidelined for too long and/or chasing returns. We would make the case for a more committed and prudent course that involves investing in high-quality, dividend-paying companies with the financial fortitude and flexibility to weather diverse market conditions.

Ultimately, the proof is in the performance. How have dividend stocks performed?

We've been dividend investors for many years; we've seen many cycles. In our experience, while dividend payers may lag the broader markets for short bursts, they've consistently done well over the long term as the market acknowledges companies' underlying fundamentals. This is very important, because investors are so distracted by the daily headlines today that they're not focused on the longer-term risk/ reward associated with the portfolio they're building.

The fact is, over time, the majority of investment return comes from dividend growth. A Société Générale study found dividend growth was the single-largest contributor to nominal returns across key developed markets over the past 40 years, providing more return than changes in stock price.

We've been hearing about dividend stocks for a while. Are they expensive by now?

Investors have been clamoring for income, and as a result, some of the highest-yielding stocks are expensive today. But this does not characterize the entire universe of dividend stocks. In fact, we're finding a great deal of opportunity among quality companies with a proven ability to maintain and grow their dividends. We see some of these companies trading at a discount right now as income-starved investors flock to the very highest yields. Our view is that investors who are willing to forgo a modicum of current yield today will be rewarded over time, with less risk along the way.

So, for you, quality trumps current yield?

Every time, and for good reason. Yield alone is not an indicator of dividend health. Often, we've found, a company that makes a high payout but has no record of consistently increasing its dividend is a company in trouble. A very high yield can be a warning sign. It can indicate a company is paying out an unsustainably high level of its earnings as dividends; or it can mean the share price is low and the company may have little prospect for future growth.

Conversely, a company that continuously pays and raises its dividend is making a strong positive statement about how it views its future prospects. There is a tremendous stigma associated with cutting a dividend, so these companies are sending a clear message by maintaining their dividend strategy—they have a lot of confidence in their businesses.

Why choose dividend stocks over more traditional income sources?

The yields offered by government and corporate bonds today are perhaps the most unappealing they've ever been. As of April 30, 2013, 409 S&P 500 companies were paying dividends, and more than 60% of those had a yield higher than the 10-year Treasury. Company bond yields are also unappetizing in many cases. As an example, one of our largest holdings recently had a stock yield of 3.25% while its intermediate-term bond had a yield of just 1.6%. And that company's dividend yield was growing at a 9% annualized rate. This illustrates one of our favorite differences between fixed income and equity income. That is, equity income has the potential to grow over time. Yes, bonds offer the certainty of a fixed coupon until maturity, but they do not offer the type of inflation-fighting income growth that can be achieved with equities. Notably, S&P 500 dividend increases historically have outpaced the rate of inflation by 1%-1.5%. (Investors should discuss the differences between stocks and bonds, including the historically greater risk of principal loss in equities, with their financial professional before making an investment decision.)

One final note: Many investors underestimate the price risk of bonds, and this is a serious issue at this point in the cycle. When interest rates rise, bond prices fall, so investors who have heavied-up on bonds over equities in recent years may be in for a rude awakening. After declining for some 30 years, bond yields cannot go much lower, and even a small uptick in rates can push bond returns into negative territory.

Any final thoughts for investors?

In an environment of slow global growth and confidencesapping policy debate, we expect volatility to remain elevated. But although the broad stock market and company earnings in general may be subject to a lot of uncertainty, the stories of individual markets, economies and companies have actually been widely disparate. In other words, there's plenty of opportunity, and it doesn't necessarily require investors to ride the roller coaster of returns in order to do well over time.

We invest for the long term so that our portfolio returns are less dependent on having to anticipate the often wild swings of the markets. We prefer a slow and steady approach to short-term gangbusters performance. We're looking to invest in companies that are committed to maintaining and growing their dividends, and we have found that this has led to stronger, more stable aggregate earnings growth over the long run. This has benefited our shareholders during tough times, because the companies we prefer are simply stronger economically and have less economic uncertainty than other companies that may have transitory characteristics that are temporarily attractive to the market. By focusing on companies with healthy balance sheets and a commitment to increasing dividends, investors can take some measure of comfort while also collecting attractive income at a time when it is so difficult to come by.

Investment involves risks. Stock values fluctuate in price so the value of an investment in stocks can go down depending upon market conditions. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments.

This material is provided as an educational tool and should not be considered investment advice. BlackRock cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided or from any other source mentioned. BlackRock is not engaged in rendering any legal, tax or accounting advice. Please consult with a qualified professional for this type of advice. The Stress Test Analysis is derived from the BlackRock Solutions® (BRS) portfolio risk model, a proprietary multi-factor model. The model uses over 111,750 distinct risk factors (including over 1,750 for fixed income, currencies and alternatives and over 110,000 for equities). In designing risk factors, BRS attempts to capture and model the key market movements that would occur in the defined scenario to illustrate the impact. There are three types of stress testing available in this tool – historical date range, BRS-constructed shocks and implied shocks. The risk model assumes that the stresses are applied to the world as it exists as of the date the report is run (data is updated monthly). Further, it assumes that the stresses take place over the course of a year and the returns shown are total returns including a year's worth of income for all income-producing asset classes. Results from this analysis will vary over time as the underlying data is updated and may vary with each use.

The opinions expressed are those of the portfolio managers profiled as of May 10, 2013, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

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