Managing a dividend portfolio when rates rise

Recent monetary tightening in Canada and the U.S. has put dividend investing in focus, and some investors may be tempted to migrate their income portfolios toward the perceived safety of bonds.

Given this backdrop, it’s important to understand how your dividend portfolio is managed. The investment philosophy that underpins Invesco Global Dividend Class¹ applies to the dividend-investing space in the current market environment.

Dividends account for approximately 50% of investment returns in the Global universe,² so including dividend-paying stocks in a diversified investment allocation for clients has proven to be a good strategy across market environments. Moreover, an analysis of historical market performance reveals that dividend-growth stocks outperform after the U.S. Federal Reserve (Fed) increases its key rate.³

The Invesco Canada Global Equities team believes there are several elements of our investment process that, when applied to dividend investing, are particularly attractive in the current environment.

With a focus on quality, our selection process favours free-cash-flow generation and high returns on invested capital. We apply these criteria to dividend investing by looking for companies that display strong growth in free cash flow – the cash that remains available to them after they pay their obligations to employees and suppliers – because it is the lifeblood of the business. It represents the “dry powder” that the business can reinvest back into operations to earn high returns and generate growth. Alternatively, management can return the cash to shareholders.

We believe this approach helps enable us to find companies that can grow their dividends sustainably. Evidence of this can be seen by the fact that Invesco Global Dividend Class tends to have a higher dividend growth rate⁴ than its peer group, higher ROIC and a lower payout ratio.⁵ This makes sense because the businesses in our Fund have more reinvestment opportunities at high rates of return; thus, they can retain more cash in the business to generate future free-cash-flow growth.

We also seek out companies with organic growth and a sustainable competitive advantage. These criteria lead us to firms that have growing and resilient earnings and cash-flow streams that are protected by unique elements in their business model and/or industry structure.

Oftentimes many dividend-paying companies have low growth and rely on debt or constant issuance of equity to fund their operations. When interest rates rise or market conditions become less conducive to equity issuance, such companies face challenges with accessing capital or covering their rising interest-rate burdens. Consequently, they may suffer declines in their stock prices.

Our approach generally allows us to avoid such companies in favour of businesses with sustainable growth that can partially fund operations through internal cash-flow generation. This helps us populate our high-conviction dividend portfolio with businesses that can compound wealth in multiple market environments.