The value of dividends in any season

by Christian Correia, CFA, CIO, Franklin Mutual Series, Franklin Templeton Investments

Franklin Mutual Series believes dividend payers can give value investors better total returns over the longer term.  

Value stocks have fared better than growth stocks this past year, benefiting from a more uneven economic outlook, rapidly rising interest rates and red-hot inflationary pressures.1 But with the economic and market outlook murkier than at the start of 2022 and earnings for many companies coming under pressure, we believe dividends should be an additional consideration in generating a substantial total return over time.

Strong signals

Dividends offer an important signal. Companies that pay consistent dividends often generate durable free cash flow. Furthermore, the dividend is usually less subject to the whims of management, and the markets, than a stock buyback. Companies can cancel or reduce their stock repurchases depending on where their shares are trading, while companies try to pay out dividends independent of stock price movements.

When examining a dividend paying stock, investors can focus on a few things, including how high the yield is or how consistently the company raises its dividend each year. A higher dividend yield does not always correspond to dividend stability, or consistency in raising it.

Those companies that provide a steady or rising dividend may have gradually increasing earnings and cash flow that is not always present in the highest-yielding stocks. And dividend raisers historically have seen their stock prices outperform those that have cut their dividend or do not pay one at all. Companies that have the highest yields have often seen their stock price fall sharply, which may indicate added stresses worth considering through deep bottom-up, fundamental analysis.

Just a cut

Getting the right dividend policy is vital for long-term value creation, in our view. As value investors, we prefer stable or growing dividends backed up by robust free cash flow generation, but we do not necessarily view dividend cuts negatively, particularly if it indicates that the company is using the cash it conserves in an appropriate way to reposition its business and reinvigorate growth.

As such, we believe that it is crucial for investors to fully appreciate all aspects of a company’s business. Through in-depth, bottom-up analysis, investors should seek to understand a potential investment’s business model, financials, and the competitive dynamics of its industry. How a company is positioned in this environment may play a role in whether a company currently pays a dividend and raises it consistently, or whether a cut is looming.

Sector spin

The rise in interest rates and the subsequent rebound in value has brought traditional dividend paying sectors, like financials and energy, back into focus. Those companies that generate their earnings and cash flow at a distant date, such as in the information technology sector, have become less attractive relative to those that book cash flows and earnings over shorter time periods as interest rates climb.

Shorter duration companies are less vulnerable to a rising rate environment since their earnings are discounted at a lower interest rate than those growth companies whose cash flows are booked far in the future. As such, value stocks, and the dividend payers among them, may be well positioned to better withstand the pressures of aggressive central bank tightening.

Moreover, as markets have struggled over the past few months, dividend paying stocks may provide some insulation from the market swings. With good cash flow generation, we believe those stocks offering dividends can provide a cushion when stock prices are down more broadly.

Europe calling

Europe may also be a beneficiary. Unlike the United States, the European economy and markets are more skewed toward value-oriented sectors such as materials, energy and financials and less exposed to growth stocks. These sectors are getting a lift from the rotation into value.

The war in Ukraine, which has curtailed energy imports from Russia and pushed up oil and natural gas prices, has given European energy producers a boost. Meanwhile, the region’s banks are benefiting as interest rates tick higher and the industry no longer faces pressure on net interest margins from negative rates.

In addition to the more value tilt of the market, European stocks generally tend to pay higher dividends than their US counterparts. The dividend yield on the MSCI USA Value Index stood at 2.87% at the end of September 2022, versus a whopping 5.21% for the MSCI Europe Value Index, according to data from index provider MSCI.2 Although the economic outlook in Europe may look more uncertain given the war in Ukraine, we expect dividends to remain a significant part of total returns for investors in Europe over the longer term.

Regardless of region, or sector, understanding a company’s growth prospects, cash flow creation and how it uses that cash remains critical in understanding a company’s value and its ability to pay a dividend, and raise it over time. Not all value stocks offer sustainable dividends, but those that do can diversify a portfolio, and potentially improve long-term total returns.3 Dividends add value.

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WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors or general market conditions. Value securities may not increase in price as anticipated or may decline further in value. Investments in foreign securities involve special risks including currency fluctuations, economic instability, and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.

Actively managed strategies could experience losses if the investment manager’s judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a portfolio, proves to be incorrect. There can be no guarantee that an investment manager’s investment techniques or decisions will produce the desired results.

IMPORTANT LEGAL INFORMATION

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.

Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

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1. Sources: MSCI Growth Index and MSCI World Value Index, through October 2022. The MSCI World Value Index captures large- and mid-cap securities exhibiting overall value style characteristics across 23 developed markets countries. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield. The MSCI World Growth Index captures large- and mid-cap securities exhibiting overall growth style characteristics across 23 developed markets countries. The growth investment style characteristics for index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI.

2. Source: MSCI. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI.

3. Diversification does not guarantee profit or protect against risk of loss.

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