Stop. Look both ways. The global dash for yield may be leading some investors into oncoming traffic.

Creators of the iconic board game Monopoly were onto something when they made receipt of a bank dividend a sought-after reward for a propitious roll of the dice.

But while the benefits of income to a stock’s total return are well known — since 1926, about 45% of the total return of the S&P 500® Index has come from dividends — investors’ increasingly aggressive hunt for yield in recent years argues for a more refined, nuanced, and calibrated approach, in our opinion (data: Lipper and Delaware Investments). In short, it’s important that investors understand that not all dividends are created equal.

In our view, the long stretch of exceptionally low real and nominal yields available from the capital markets since 2008 has led to a state in which many investors have become willing to overreach for dividend income. Indeed, what appears to be severe overvaluation of some income-producing equities (most notably in the utility, consumer staples, and telecom sectors, where relative valuations are near 50-year highs) is further evidence that yield-starved and — ironically — risk-averse investors are aggressively chasing yield: the higher the better, with few other questions asked.

Misleading numbers — when 4 is bigger than 6

It is illusory, in our opinion, to view a stock yielding 6% as necessarily a better investment than one yielding 4%. The historical record reveals that while dividend-paying companies overall have bested those that don’t pay dividends or those that cut their dividend payment, total returns have historically been highest on companies that actively grow their dividends, as distinct from those that simply pay dividends. (Of course, there is no guarantee that dividend-paying stocks will continue to pay dividends.)

Over the 16-year period ended December 2012, dividend growers returned, on average, 6.9% per year on a market-weighted total return basis, compared to 6.8% for all dividend payers, 6.1% for non-dividend payers, and -1.1% for companies that cut their dividend distributions. (Data: RBC Capital Markets, February 2013.)

Total returns (December 1996–December 2012, market weighted, %)

Source: RBC Capital Markets Quantitative Research, January 2013.

Chart is for illustrative purposes only. Past performance does not guarantee future results.

Companies within the S&P 500 Index are classified as dividend growers when they have increased their dividend declarations anytime during the last 12 months. Companies within the S&P 500 Index are classified as dividend payers if their dividend declarations have been unchanged, or no change in their dividend policy for the prior 12 months. Companies within the S&P 500 Index are classified as dividend cutters if they have decreased their declared dividend rates anytime during the past 12 months. Companies within the S&P 500 Index are classified as non-dividend payers when they maintain a stated annual dividend rate of zero.

The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the U.S. stock market. An index is unmanaged and one cannot invest directly in an index. All third-party marks are the property of their respective owners.

The individual companies that fall into each classification are closely monitored by the data provider. Any changes to a company’s dividend policy are reflected in the company’s dividend classification. Company dividend classifications are typically updated by the data provider on a monthly basis.

There is no guarantee that dividend-paying stocks will continue to pay dividends.

Equally important, the outperformance of dividend growers was accomplished with reduced volatility. Over that same 16-year span, market-weighted annualized volatility among dividend growers was 14.3% versus 15.4% for all dividend payers, 16.3% for the S&P 500, and a whopping 23.3% for non-dividend payers and 29.7% for dividend cutters. (Data: RBC Capital Markets, February 2013.) Most recent data available.

Annualized volatility (December 1996–December 2012, market weighted, %)

Source: RBC Capital Markets Quantitative Research, January 2013.

Chart is for illustrative purposes only. Past performance does not guarantee future results.

The figures above clearly demonstrate to us that there is more to investing for equity income than simply choosing the highest-yielding stocks, especially since determining a company’s ability to grow its dividend requires specialized research capability. Equity-income managers are expected to identify companies whose dividend growth could stagnate, increase, or reverse before that information becomes embedded in a stock’s price.

Sending a message

The most astute corporate boards and management teams also recognize that dividends are an important signaling mechanism to investors. Accordingly, significant time and energy is (or should be) expended in crafting a prudent and sustainable dividend policy.

Regularly increasing, rather than simply maintaining, or worse, cutting a dividend, typically functions as a clarion call to the market about the health of an underlying business, both for now and in the future.

The danger in simply chasing yield is evidenced to us in healthcare and mortgage real estate investment trusts (REITs) despite their high current yields. Healthcare REITs are currently trading near a 45% premium to their net asset values, have generally inadequate coverage ratios, and, in our opinion, could be vulnerable to Medicare cuts. Meanwhile, mortgage REITs are especially susceptible to changes in the shape of the yield curve and to prepayment risk. (Data: Bloomberg.)

Like mortgage REITs, companies that sport elevated but static dividend yields are usually vulnerable to sharp upward moves in interest rates. Typically, such businesses eventually become viewed as “yield hogs,” offering investors scant intrinsic growth to offset the valuation contraction that generally accompanies rising bond and/or cash yields. The ability to increase dividends reflects a company’s free cash flow, and thus could attract a broader class of investors — those seeking growth as well as income. Retaining capital also allows a business to finance operations internally at no cost.

It is also important to note that, from our perspective:

  • Even a growing and well-covered dividend is not a sufficient reason to own a stock.
  • In doing due diligence, it is vital that the company’s longer-term outlook appear favorable as well.
  • A diversified income-producing fund should have the flexibility to selectively exploit attractive income opportunities outside the equity asset class (such as in high yield bonds, real estate, or the mostly inefficient convertible bond space).

Like moths to the flame…

Of course, we recognize that individual and institutional investors alike often are drawn toward whatever product is considered hot, and in the current, unnaturally low rate environment, chasing dividend yield has generally been a profitable enterprise. Then again, so was buying dot-com stocks in the late 1990s, or Miami condos in the mid-2000s.

This is not to suggest that an equal comeuppance awaits the most egregious forms of equity yield-chasing in coming years. We are mindful, however, that even sound strategies can be taken to unreasonable extremes, and the indiscriminate accumulation of the highest-yielding stocks on that basis alone is misguided in our view.

We view the global dash for yield as being in its later innings, and believe that the time has arrived to be more discriminating in choosing dividend-paying stocks. Credit quality, not the size of the dividend, should be of paramount importance. While we cannot know when the income-chasing game will end, for investors who have accepted the flawed premise that more is better when it comes to dividends, we doubt that it will end well.

The views expressed represent the Manager’s assessment of the market environment as of June 2013 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager’s current views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Certain statements made here are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 (PSLRA). A forward-looking statement is a statement that is not a historical fact and, without limitation, includes any statement that may predict, forecast, indicate or imply future results, performance or achievements, and may contain words like: "believe," "anticipate," "expect," "estimate," "project," "will," "shall" and other words or phrases with similar meaning in connection with a discussion of future operating or financial performance. In particular, these include statements relating to future actions, trends in our businesses, prospective services or products, future performance or financial results, and the outcome of contingencies, such as legal proceedings. The protection afforded by the safe harbor for forward-looking statements provided by the PSLRA are claimed hereunder.

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from the results contained in the forward-looking statements. Investors should not place undue reliance on forward-looking statements as a prediction of actual results. In addition, we disclaim any obligation to update any forward-looking statements to reflect events or circumstances that occur after the date of this document.

Narrowly focused investments may exhibit higher volatility than investments in multiple industry sectors. Technology companies may be subject to severe competition and product obsolescence.

REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations. A REIT fund’s tax status as a regulated investment company could be jeopardized if it holds real estate directly, as a result of defaults, or receives rental income from real estate holdings.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. Funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by a Fund may be prepaid prior to maturity, potentially forcing a Fund to reinvest that money at a lower interest rate.

High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds.

Diversification may not protect against market risk.

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