By Carl Van Nieuwerburgh,
DPAM quantitative equity strategist


During the turbulent Covid crisis, the performance of Dividend Yielding (DY) stocks was disappointing. In this article, we investigate why and answer the question of whether we can still expect them to behave defensively in the next crisis. We also compare the defensive properties of high DY stocks in the US and Europe.

Investing in high DY stocks has been perceived as a defensive investment strategy – a kind of bond-like equity investment. This view was reinforced by the observation that in the past, high DY stocks performed relatively well when bond prices increased. When economic troubles occur, sovereign rates often decline due to the prospect of easing by central banks. In these circumstances, high DY stocks historically declined less than the overall market. The reason for their defensive behavior lies in the foreseeability of the dividend income streams they generate. The importance of this dividend income implies that their valuation is less dependent on future growth. As uncertainty surrounding future growth and the risk premium used to discount future growth increase during economic turbulent times, high DY stocks are better positioned to withstand the turmoil.

However, for high DY stocks to truly profit in these circumstances, it is necessary that the expectations for the income they generate do not decline too much as a result of economic uncertainty. After all, a stock’s DY can also be high because its share price can incorporate worsening prospects faster than analysts’ dividend forecasts do.

The degree to which DY stocks outperform in turbulent times demonstrates the balance between these two opposing forces. In the chart below, we can see that during the tech bubble implosion, the GFC, and the Euro crisis, the foreseeable dividend stream was strong enough for high DY stocks to offer a lower drawdown than low DY stocks. However, this was not repeated during the Covid crisis. At that time, US and European high DY stocks declined substantially more than low DY stocks. High DY stocks were not a defensive safe haven during the pandemic.

Source: DPAM, 2023

As a consequence, the relationship between rate movements and the relative return of high DY stocks inverted: DY stocks underperformed when rates declined – a historic anomaly. And it did not stop there. With central banks subsequently fighting inflation and a growth bubble deflating, high DY stocks then outperformed strongly in a rising interest rate environment. In short, DY stocks behaved as cyclical value stocks, geared towards the economic cycle, just like low PB stocks. The question then arises: why, and will this trend continue going forward?

The chart below shows that a deterioration in high DY stocks’ relative growth played an important role. High DY stocks always grow slower than their peers because they pay out a larger part of their earnings rather than invest in growth. During the pandemic, however, the difference in expected growth deteriorated rapidly to unseen levels. The acceleration in digitalization likely contributed significantly to this evolution. So, rather than seeing the uncertainty around future growth weigh on the profitability of growth companies’ investments, the pandemic proved to be, on average, a boon for growth stocks.

Not all of this was irrational or merely a pull forward of future growth. Some of the increased gap in growth expectations for high and low DY stocks still remains today. At the moment, high DY stocks’ relative growth expectations are still near the bottom of the range witnessed in the two decades prior to the Covid crisis. Growth prospects for high DY stocks are still weak compared to their own history.

Interestingly, revisions to expected dividends were not more negative during the Covid crisis than in previous crises. So, they do not explain the disappointing performance of high DY stocks during the pandemic. Neither was the increase in expected payout higher than in the past.

Source: DPAM, 2023

We now turn our attention to the profitability and quality of high DY stocks. Has there been any meaningful shift in these areas? The graph below shows that, at first, high DY stocks’ relative return on equity (ROE) did worsen during the Covid crisis, but its decline was less dramatic than the decline in relative growth. Subsequently, it also bounced back quickly and even posted a new record high in the US. As a result, the relative ROE is reassuring for investors in high DY stocks who are looking for defensiveness.

Margins are another dimension of profitability and quality. The chart below shows margins do not show a structural negative shift either. Still, the relative margin of European high DY stocks is quite low compared to its own history, indicating lower quality.

Source: DPAM, 2023

Next, we look at the expected payout for high DY companies. This is another angle to investigate when examining defensiveness, as high payouts can indicate a higher probability of dividend cuts. The chart below shows that high DY stocks’ payout increased materially during the Covid crisis but fell sharply afterwards. At the moment, the payout does not seem stretched – another sign that can reassure dividend investors.

As a final test, we check the evolution in high DY stocks’ relative volatility. Today, high DY stocks are less volatile than low DY stocks, both in the US and in Europe, even though the relative volatility increased sharply in the US recently.

Source: DPAM, 2023


High DY stocks disappointed during the Covid crisis, and since then, the link between their relative returns and interest rate movements remains at odds with what was previously observed. We do not expect this relationship to come back immediately, unless Central Banks are done taming inflation via monetary tightening.

Investigating high DY stocks’ fundamentals, though, we are reassured that investing in high DY stocks can behave as a defensive investment strategy again in the future. While high DY stocks’ relative growth is still weak, their relative profitability is in line with the past, and they are clearly less volatile than their peers. The sole explanation for high DY stocks’ disappointing performance was the unique environment during the pandemic, in which extremely high uncertainty was combined with strongly improved expectations for growth stocks.

Region-wise, it is noteworthy that high DY stocks display better defensive properties in the US than in Europe, with comparatively better relative ROE and margin, a lower pay-out, and more favorable relative volatility.

As a final note, we observe that the performance of US equity factors in the first two months of this year is very much explained by their respective volatility – to the extent that we could say that volatility has been the one and only factor explaining US equity factors. With high DY stocks being the second least volatile equity factor – behind investing directly in the low volatility factor – this has held back their performance in an upward-moving market.

Source: DPAM, 2023


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