Make Your Large Cap Work Double Duty
Equity Dividends Can Help You Find Income and Growth in Different Places
By Alexis Petrakis
Any investor needing exposure to equities likely will want a sizable allocation to large capitalization stocks. That makes perfect sense, and the DC investment menu typically fills that slot with the large cap allocation within its target date fund, an S&P 500 Index fund, and maybe even a large cap growth fund. Certainly those can be logical choices as part of a core portfolio holding for virtually any plan participant.
But is this adequate? Or is this simply investing the way your grandfather did? Given our new investment landscape, an argument can be made that we all need to step back and rethink the large cap equity segment of the portfolio. Today, many DC plans might consider offering a dividend-paying equity vehicle for its growth potential and its ability to help participants meet their income needs. With a premium on streamlined DC investment menus and overall efficiency, getting double duty out of the large cap asset class is an attractive possibility.
Historically, DC plans were built almost exclusively with accumulation in mind and they have admirably served this role by providing participants an easy avenue to save. But now as DC plan sponsors and providers enter a new era with millions of Baby Boomers retiring each year, we need to ask more of our DC plans. They need to make the shift to facilitating income decumulation by making sure that participants have the tools to meet the significant income challenge that lies directly ahead.
Just as this paradigm shift is occurring, DC plans have had to navigate the period of tremendous volatility and uneven investment performance that began in 2008. While the markets have rebounded, many traditional approaches to large cap investing remain challenged. "There's a dual need for many plans looking to fill their large cap option," says James Carville, a member of the US & Canada Defined Contribution team. "A dividend equity strategy can be used to fill a large cap equity allocation by offering growth potential while also pitching-in to help with current and future income needs."
As Carville points out, viewed strictly from a total return perspective, dividend equity strategies have an attractive track record. (See the sidebar "Weathering the Storm?") That alone may convince plan sponsors that their menu needs to be expanded to include a dividend equity strategy. But can a large cap allocation also be a source of income generation for participants?
"Will work for yield"
Historically, one of the centerpieces for investors seeking stable retirement income has been Treasuries. Yet over the past 30 years we've seen an unprecedented rally in bonds that has driven yields down from the mid-teens in the late 1970s to 2%* and below earlier this year. As a result, investors are looking elsewhere for income.
This has occurred just as traditional sources of retirement income are losing considerable steam. Defined benefit plans are becoming fewer and farther between as more and more companies and municipalities convert to DC plans. In addition, a forward-looking actuarial analysis of the social security safety net does not paint a pretty picture for any households that plan to rely solely on this income to maintain their current lifestyle.
Compounding matters are a host of demographic and cost-of-living trends. In the US and Canada, the number of retirees is set to double to 125 million by 2050. Obviously, there's a great deal of income that needs to be generated for the soon-to-be retired, and there's no doubt that much of this pressure will be heaped on DC plans. Plans and individual participants seeking yield are forced to cast a wider net.
"Adding an equity dividend strategy to a traditional income-generating portfolio is one way to add to returns and increase yield," says Carville. "It can be particularly effective in the new low-yield environment in which we find ourselves."
Whether added to a fund lineup or incorporated into a target date or balanced fund, equity dividend funds can prove versatile. "Executed properly, a dividend strategy can fill multiple roles within in a DC menu because it offers investors the potential of reliable income stream wrapped in a capital appreciation vehicle. This is ideally suited for today's world."
In other words, the potential benefits don't end with income. Dividend paying stocks are versatile, all-weather performers. In bull markets they participate to the upside, while in bear markets they have been shown to weather the downturns better than growth strategies. (See "Weathering the Storm") And in a prolonged, low-growth environment similar to what appears to be emerging today, high-dividend equities have proven to substantially outperform non-dividend paying stocks.
"We understand that many participants are still a bit leery of stocks after from seeing their account balances plunge in late 2008," admits Carville. "However, the fact is that dividend equities can be a good anecdote for volatility, and thus they can help insulate against dramatic valuation swings."
Weathering The Storm?
While dividend strategies offer an attractive source of income in today's low-yield environment, they have also delivered strong returns historically.
Average Returns from 01/13/72 to 12/31/11
Source: Ned Davis
Equity Dividend Strategies in Action
For years an equity dividend strategy was viewed as a niche, often embraced by risk-averse investors who needed exposure to equities but were only willing to dangle a toe into the market. This narrow perception is finally beginning to change thanks largely to the realization that dividend-paying stocks may be ideally positioned to excel in the current low-rate environment.
Nevertheless, not all equity dividend funds are created equal. Some managers churn the portfolio, which inflates the total cost structure and makes them tax inefficient vehicles. Others ignore potential red flags and reach for the highest yielding companies exclusively.
"It's important for investors to look closely at the strategy behind their chosen dividend equity vehicle to make sure it's not driven exclusively by yield," warns Ryan McNulty, product specialist with BlackRock's Equity Dividend team. "Rather, the focus should be on total return where both capital appreciation and income contribute. We want all our portfolio companies to exhibit balance sheet strength and prudent management."
While a top down or thematic approach can help focus attention to the right universe of companies, managing risk and weeding out the pretenders requires both traditional financial statement analysis, as well as access to the C-suite for any potential portfolio company.
McNulty explains that meetings with company management are critical because they provide a more holistic view to help the team understand the company's cost structure, its capital allocation plan, and whether there's any near-term catalyst to drive future business growth.
For BlackRock's Equity Dividend team, the process is centered around a bottom up approach predicated on digging deep into company fundamentals. There are three primary screens used in securities selection.
1. All companies must pay a dividend, though there is no minimum yield requirement. Generally speaking, history has shown that divided payers in the neighborhood of 2% to 3% have proven to be in the sweet spot, exhibiting the discipline to maintain a delicate balance between kicking-off cash to shareholders without neglecting to reinvest in their own business.
2. Consider companies with a market cap of $5 billion or more to keep the focus squarely in the large cap universe. This confirms that the fund is indeed a large cap alternative or supplement. Not all dividend funds are.
3. Portfolio companies should have a debt-to-book ratio of less than 50%, which sends a signal that the company is not maintaining a dividend with the dangerous overuse of leverage.
It's Not Too Late
As dividend strategies have gained new fans, many investors are wondering whether it is still an appropriate time to get on board. From a historical perspective this sector has outperformed the broader equity market since inception. And from a valuation standpoint, now appears is a great time to be a portfolio manager in this space.
"After the recent financial turmoil, many US multinational companies have emerged very lean and with very clean balance sheets," explains McNulty. "Companies have more cash on hand than they have in decades, yet payout ratios are bumping along at historic lows. This bodes well for the entire sector since payout ratios still have a long way to go before getting to back to their long-term average."
From a macro perspective, let's not forget that money flows to the taxable fixed income sector have been staggering since the global financial crisis. But as stability returns to the capital markets, this risk-off move to Treasuries will probably unwind to some extent, and equity income stocks are a logical destination. This is yet another reason that a prudent equity dividend strategy makes a compelling large cap alternative, or supplement, in the current environment.
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