For some time, high-paying dividend stocks have been one of the best ways for yield-hungry investors to find an alternative to low-paying bonds.
But as the interest rate landscape begins shifting toward a rising rate environment, high-yielding investments are going to look less attractive, experts say.
Be smart. When it comes to dividend stocks, the smart move in a rising rate environment is to focus on companies that are growing their dividends, rather than focusing on the largest possible payout.
“Rising rates decrease the attractiveness of high-dividend stocks,” says Christian Magoon, CEO of Amplify Investments in Wheaton, Illinois.
[See: 20 Awesome Dividend Stocks for Guaranteed Income.]
That’s because traditional high yielders such as utilities, telecom and consumer staples companies compete with government bonds for capital. As rates rise, low-risk Treasury securities start yielding more and become more competitive. The spread narrows between them and high-yield dividend stocks, which are already yielding as much as they can.
And if inflation increases — which often goes hand-in-hand with central bank interest rate hikes — distributions lose more of their purchasing power.
High-yielding stocks lose their luster. Higher interest rates tend to coincide with better economic activity, says Mark Spellman, portfolio manager with Alpine Woods Capital Investors in Purchase, New York.
When the economy is doing better, investors often want to take more risks and potentially reap more rewards than the traditionally safer high-yield stocks can offer, he says.
The massive demand for high-yielding stocks has left them vulnerable to a large correction when investors move toward dividend growth stocks, such as consumer discretionary companies, says Eric Ervin, CEO of Reality Shares, an asset management company in San Diego.
Companies that have room to grow their dividends can outpace inflation and rise fast enough to keep their payout spread over rising interest rates.
Typically, dividend growth stocks are valued at a price-earnings premium over yield-oriented stocks because they tend to outperform over time and they signal a healthier company, Ervin says. But now they’re at a discount because there’s more of a demand for high-yielding stocks.
Look to the Fed. The Federal Reserve, which left the federal funds rate unchanged on Wednesday, could follow its playbook from last year and be more dovish than it has indicated, Magoon says.
But over the next three to five years, odds are that interest rates will rise, which means now may be a good time to get dividend growth at a bargain, he says. “Now is a great time to begin shifting assets over in anticipation of a potential rise in rates.”
[See: 7 Dividend Stocks to Buy That Pay More Each Year.]
Magoon recommends a blend of high-yield stocks and dividend growth stocks, gradually blending in the latter because of uncertainty over the Fed’s course on interest rates. Assuming a portfolio of 100 percent dividend stocks, he suggests having just 25 percent as dividend growth stocks, he says.
For broad dividend growth exposure, Magoon suggests the Vanguard Dividend Appreciation exchange-traded fund (ticker: VIG) and the ProShares S&P 500 Dividend Aristocrats ETF ( NOBL).
But because both of these funds are based on companies’ dividend history, they can miss pockets of dividend growth from companies such as Apple ( AAPL) or Gilead Sciences ( GILD) that haven’t had enough consecutive years of dividend growth to make the cut.
“That’s where all the dividend growth is,” says Ervin, whose company is behind a dividend health analysis system that aims to predict future dividend growth. Top holdings in its Divcon Leaders Dividend ETF ( LEAD) include Tyson Foods ( TSN), Nvidia Corp. ( NVDA) and Texas Instruments ( TXN).
That compares with a company like Exxon Mobil Corp. ( XOM), which has been growing its dividend for decades but has been facing headwinds because of the downturn in the energy economy, he says. The company’s dividend payments have grown by an average of 6.4 percent a year over the last 34 years. But that slowed to 3.5 percent annual growth last year.
Spellman, who manages the Alpine Rising Dividend Fund ( AAADX), looks for positive free cash flow and earnings, which allows companies to raise their dividends faster than inflation.
He points to Starbucks Corp. ( SBUX), which exposed to consumer spending and has room to expand in China. It has a dividend yield of 1.85 percent. Another stock is Amgen ( AMGN), which has strong cash flow and is cheap at the moment, he says. AMGN stock has strong dividend of 2.9 percent.
[See: 7 of the Best Stocks to Buy for 2017.]
Each has been increasing their dividend for the last six years, and Spellman says they have has ample room for continued growth.
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The Difference Between Dividend Growth Vs. Yield Stocks originally appeared on usnews.com
