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Tailored Portfolios | Disciplined Investment Process 2015 DIVIDEND STOCK INVESTMENTS IN A RISING INTEREST RATE ENVIRONMENT • Dividend-focused strategies deserve special focus from long-term investors. • Not all dividend stocks will perform in the same manner when rates begin to rise. • When a central bank makes its first increase of interest rates, this generally signals a fast growing economy. www.capstonefinancial.com Dividend Stock Investments in a Rising Interest Rate Environment The Historic Relationship between Dividends and Returns When long-term investors consider returns, many different metrics and questions come to mind: What is the company’s operating margin? Does the company generate enough cash flow to support its business model? What are the long-term prospects of the company’s business model? While these questions are important, the aspect of total return that does not always receive enough attention is the company’s dividend and how it contributes to return. Over the last 75 years, dividends account for 44% of the total return of S&P 500 companies.1 While there are many investing strategies, dividend-focused strategies deserve special focus from longterm investors. Dividend Strategies in a Rising Rate Environment When interest rates are at historical lows and rates are expected to rise in the near future, a special question arises: How will rising rates impact a dividend-focused stock portfolio? Considering a generic stock in isolation, the rising cost of borrowing appears as a net negative. However, rates generally rise because the economy is growing at a healthy pace. As a consequence, a central bank uses monetary policies (like rising rates) that may help prevent the economy from overheating. The other generic rising rate scenario occurs when central banks raise rates due to inflation. This policy may signal a negative trend in the macro-economic environment. So long as the market allows, corporations have the ability to pass inflation through to consumers by raising prices. However, purchasing dividend While dividend paying stocks stocks could in some respects be considered an inflation hedge when with characteristics similar to companies pass on higher prices to bonds – like utility stocks – may consumers and reward investors with spell trouble in a rising rate higher dividends financed by these environment, other dividend elevated prices. paying stocks may perform better or exceptionally well in the same scenario. Given the complicated relationship between rising rates, stock prices, and dividends, the answer to the question of how rates impact divided stocks is not a simple matter. The impact of rising rates will depend on many variables specific to a particular dividend paying stock. In other words, not all dividend stocks will perform in the same manner when rates begin to rise. 1 Savage, Terry. Dividends, Buybacks Help Drive Stock Returns. Chicago Tribune. June 2, 2015. Page 2 of 4 Dividend Stock Investments in a Rising Interest Rate Environment Stocks Which Resemble Bonds Will Underperform The type of dividend paying stocks that would be impacted negatively by rising interest rates are those that most closely resemble bonds. A sector that illustrates this well is utilities. Utility companies generally have high dividend yields and their revenue streams are less sensitive to economic conditions. That means there is less risk to earnings during times of recession, but the tradeoff is minimal growth potential during high economic growth periods. In other words, a utility stock offers what amounts to a fixed income stream, with a minimal dividend growth component and some upside or downside potential. These are some of the same factors that cause a bond’s price to fall when rates rise. Thus, as rates begin to rise, stocks with characteristics similar to bonds will begin to underperform. This is a significant point for dividend investors. If yield is your primary deciding factor for dividend investments, it could potentially lead you to a portfolio of assets that are highly sensitive to interest rate movements. It also can concentrate your holdings into a specific sector or industry, further increasing your investment risk due to lack of diversification. While dividend paying stocks with characteristics similar to bonds – like utility stocks – may spell trouble in a rising rate environment, other dividend paying stocks may perform better or exceptionally well in the same scenario. A Better Dividend Stock Option The key to investing in dividend-paying stocks that perform better in such an environment is to identify companies that have the potential to increase their payouts and have historically increased dividends in the past. Stable, high quality companies with a long history of increasing dividends on a regular basis fall into this category. Generally, these companies are considered long-term core holdings. These stocks have historically outperformed during periods of rising rates. Another positive attribute to explore are companies that become more profitable during periods of rising rates. In the financial sector, banks on average perform well, because they may be able to earn more profits if interest rates on loans rise. Other historical outperformers include firms which earn interest on money held temporarily for their clients. A payroll company serves as a salient example of this type of company. When a central bank makes its first increase of interest rates, this generally signals a fast growing economy that should continue to expand and benefit those companies that are more economically sensitive. Technology companies tend to fall into this category, because they tend Page 3 of 4 The key to investing in dividendpaying stocks that perform better in such an environment is to identify companies that have the potential to increase their payouts and have historically increased dividends in the past. Dividend Stock Investments in a Rising Interest Rate Environment Page 4 of 4 to be more economically sensitive while simultaneously carrying little debt. This characteristic minimizes the cost drag related to rising borrowing costs. Consumer discretionary stocks also generally perform well in this scenario as consumer demand for non-essentials increases during periods of economic expansion. Dividend-paying companies in these industries and sectors can increase their revenue and earnings while maintaining, and ultimately increasing, their dividend payout rates. Unlike a bond, a dividend stock can simultaneously increase its payout rate and increase its entity value. This overrides any drag associated with a rise in rates. Not All Dividend Strategies Are Equal An investment decision in dividend paying stocks during rising rates involves many individual company variables along with an evaluation of the current market environment. From a portfolio construction perspective, the challenge becomes avoiding sector and industry concentration risk without sacrificing dividend yield. Overexposure to certain sectors and equities which behave like certain fixed income instruments are common flaws for some dividend strategies that have high yield targets. High yield dividend portfolios must be carefully managed as interest rate movements can affect the risk profile of the portfolio and provide performance results that do not match long-term expectations. Information and recommendations contained in Capstone Asset Management Company’s market commentaries and writings are of a general nature and are provided solely for the use of Capstone Asset Management Company, its clients and prospective clients. This content is not to be reproduced, copied or made available to others without the expressed written consent of Capstone Asset Management Company. These materials reflect the opinion of Capstone Asset Management Company on the date of production and are subject to change at any time without notice, due to various factors, including opinions or positions. Where data is presented that is prepared by third parties, such information will be cited, and these sources have been deemed to be reliable. However, Capstone Asset Management Company does not warrant the accuracy of this information. The information provided herein is for information purposes only and does not constitute financial, investment, tax or legal advice. Investment advice can be provided only after the delivery of Capstone Assets Management Company’s Brochure and Brochure Supplement (Form ADV Part 2A&B) and once a properly executed investment advisory agreement has been entered into by the client and Capstone Asset Management Company. All Investments are subject to risks. Capstone Asset Management Company is an investment adviser registered with the SEC. Registration as an investment adviser with the SEC does not imply a certain level of skill or training. Capstone Asset Management Company | 3700 West Sam Houston Parkway South #250 | Houston, Texas 77042 Phone: 713.260.9000 | Toll Free: 800.262.6631 | Fax: 713.260.9050 E-mail: [email protected] | www.capstonefinancial.com November 2015