Dividend Investing in a Strong Earnings Season
In recent years, economists have been predicting a downturn. They argue that since we have moved into the latest stage of the business cycle, the next stop for the U.S. economy would be a recession.
But that didn’t turn out to be the case, at least from the data we’ve seen so far. According to the Bureau of Economic Analysis, U.S. real gross domestic product (GDP) expanded at an annual rate of 3.2% in the first quarter of 2019. The number was higher than what economists were expecting and marked the first time that U.S. first-quarter GDP growth topped three percent since 2015. (Source: “Gross Domestic Product, First Quarter 2019 (Advance Estimate),” Bureau of Economic Analysis, April 26, 2019.)
The labor market is doing great as well. Economists expected the U.S. economy to add 190,000 jobs in April 2019. Earlier this month, the Bureau of Labor Statistics revealed that non-farm payroll employment actually increased by 263,000 in April, easily beating economists’ estimate. Moreover, the unemployment rate fell from 3.8% to 3.6% for the month, marking its lowest reading since December 1969. (Source: “Employment Situation Summary,” Bureau of Labor Statistics, May 3, 2019.)
At the same time, corporate earnings seem to have turned out better than expected. According to FactSet Research Systems Inc, among the 78% of S&P 500 companies that have reported first-quarter earnings as of May 3, 76% of them have beaten their earnings per share (EPS) estimates and 60% of them have delivered positive revenue surprises. (Source: “Earnings Insight,” FactSet Research Systems Inc, May 3, 2019.)
Add it up and you’ll see that there were plenty of reasons to keep market participants happy. And indeed happy they were: year-to-date, the Dow Jones Industrial Average climbed 11.7%, the S&P 500 Index rose 15.4%, and the Nasdaq Composite surged a whopping 19.6% thanks to investors’ enthusiasm toward many of the large-cap tech stocks.
So, what does this mean for income investors?
Well, if you own a bunch of dividend stocks, a strong earnings season should be good news. This is because in order for a company to afford its dividend, it needs to generate enough profits to cover the payout. Therefore, when a company is making more profits than what people were expecting, it certainly sends a positive message to the company’s dividend investors.
But what about investors who are looking for dividend stocks to buy?
Well, that means they’ll probably face higher price tags on many of the popular dividend stocks. As the market rallied, valuations have generally gotten more expensive. According to FactSet, S&P 500 companies now have a forward 12-month price-to-earnings ratio (P/E ratio) of 16.8 times. This is substantially higher than their 10-year average forward P/E ratio of 14.7 times. (Source: Ibid.)
Due to the inverse relationship between dividend yield and stock price, rising share prices could cause yield to be subdued. And that’s indeed the case here. Thanks to a prolonged bull market for the most part of the last decade, the average dividend yield of all S&P 500 companies stands at just 1.9% at the moment. To put it in perspective, the historical average dividend yield of companies in this benchmark index was 4.3%. (Source: “S&P 500 Dividend Yield,” Multpl.com, last accessed May 9, 2019.)
So, where does that leave us?
For those who are yet to build their income portfolio, I would suggest looking into the dividend growth stocks. This is because while yields are pretty low by historical standards, if a company can raise its payout on a consistent basis, shareholders will be able to collect a higher yield-on-cost as time goes by.
Also, focus on the recession-proof businesses. The reason is simple: despite the fact that we are not in a recession at the moment, the economists are right in that our economy moves in cycles. This means at some point down the road, there will be a downturn. And as long-term income investors, you’ll want to make sure that your portfolio companies can keep paying you dividends even when the going gets tough.
Looking back, we see that recession proof dividend growth stocks have served income investors well over the long run. Procter & Gamble Co (NYSE:PG), Johnson & Johnson (NYSE:JNJ), and PepsiCo, Inc. (NASDAQ:PEP) are good examples of companies that have been paying increasing dividends through thick and thin.
And if you are wondering whether these popular tickers have gotten too expensive, remember that the legendary Warren Buffett once said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”