Dividend Investing – Smoother Ride in a Volatile Market

* BMO Dividend Fund increased its series F distribution from 12 cents a unit to 20 cents a unit for 2022. The new 20 cent distribution is used in the yield calculation.

Source: BMO Global Asset Management, as of April 30, 2022. Distribution yield is not an indicator of overall performance. Yields will change from month to month based on market conditions and is not guaranteed. See appendix for the full disclaimer.

Introduction

• In recent years, investors have experienced unprecedented levels of volatility and uncertainty in the markets. These bouts of volatility come with little notice, and investors need to be prepared for it. In 2020, we saw volatility due to a pandemic, and at the beginning of 2022, we saw volatility, led by inflation fears and a rising yield environment. How can investors protect themselves and have a smoother ride through these ups and downs?
  • One tried-and-tested method is investing in companies that have weathered different market cycles over the long term. This is where the power of investing in stable dividend-paying companies comes in.
  • Companies that have paid a steady dividend over time are typically those with capable management teams and strong fundamentals. Dividend-based investing has been quite strong, with dividend-growers leading the pack vs. the broad market. Furthermore, companies that pay a dividend and grow it over time have the potential to deliver better returns with less volatility.
• We have seen a significant increase in inflation across the world, driven by supply chain issues; however, once these issues are resolved, inflation should start to revert. During these falling inflation cycles, equity tends to perform well, although one needs to be cognizant of the type of equity in their portfolio. In this rising interest rate environment, growth tends to underperform vs. value/quality. BMO’s suite of dividend Funds provides a perfect mixture of value/quality companies that tends to provide lower volatility with stable, growing dividends.
• Lastly, BMO’s suite of dividend covered call Funds have the potential to provide investors with higher yield, with the dividend factor. Given that volatility is elevated, due to inflation risk/a hawkish Federal Reserve, geopolitical tensions in Europe, and COVID-19, option premiums are very attractive, and at the same, allow us to write further out-of-the-money calls, offering more upside participation for the portfolio.

Value/Quality Outperformance in Rising Interest Rates

Source: Bloomberg, BMO AM Inc. Canadian Factor Returns are pure factor returns for the S&P/TSX Index from January 2000 to January 2022.

• At the beginning of 2022, the majority of central banks across the world began to increase interest rates to help cope with inflation.
• As per the chart above, we can see that during periods of rising yields, value/quality equities have assumed a leadership role in the equity market.
• Value/Quality stocks potentially can be well positioned in the face of rising yields. They can provide high return on equity. In addition, stable earnings tend to have competitive advantages and are leaders in their respective industries. As a result, these companies may have better ability to pass higher input costs to end consumers, resulting in better protecting earnings. In addition, a lower financial leverage means these companies tend to have lower debt, potentially leaving them less burdened due to higher interest rates.
  • Dividend-based strategies tend to be correlated with value.
• During this period, growth stocks tend to lag, since a significant portion of their cash flows are further in the future. While traditional value sectors such as Financials and Energy have been leaders during these periods.
  • Financial companies benefit from increase in net interest margins
  • Energy companies benefit from strong commodity prices
    

Equity Performance in Falling Inflation Cycle

Exhibit 3: Given Current Annual CPI Rate and Inflation Forecasts, the Next Cycle Is Likely to Be a Falling Y/Y CPI One

Falling CPI Cycles and S&P 500 Annualized Total Return

based on y/y %change in CPI; 12 total cycles since 1990

cycles are defined where there is at least a 6-month trend in the overall y/y change in the CPI rate

Source: BMO Capital Markets Investment Strategy Group, FactSet, Haver, BLS.

• Another systematic theme for 2022 is inflation, with US CPI at 8.3%, and CAD CPI at 6.7% and at multi-year highs. While inflation poses a risk to equity returns, during renormalization falling inflation rate cycles, which we are likely to experience in 2022, equity performance tends to be strong.
• In the table above, it shows on average, equities returns are strong in low double digits which is much higher compared vs fixed income. Inflation is at the highest levels in decades. This is mainly caused by supply chain issues, fiscal/monetary policy, and strong job market (with higher wages). However, as monetary policy is adjusted to tackle this & supply chain issues are resolved, inflation should start to cool off in the second half of 2022. During this period of falling inflation, equities should outperform as seen in the table above.
  • As a further note, during such period value and dividend-based strategies have historically performed well.

Source: Bloomberg, BMO Asset Management, as of April 30, 2022.

• These Funds are constructed by investing in high-quality companies with a sustainable/growing dividend.
• Above are some selected companies held in the portfolios, from a variety of industries and regions, that have raised their dividends. In general, corporate financial health is strong, with credit spreads low, and many companies are cash rich, which should lead to solid dividend growth and resumed share buybacks throughout the remainder of 2022.
• For investors who follow dividend streams as a methodology to value companies, such increases are meaningful.

Source: BMO Global Asset Management. Series F returns as of April 30, 2022.

Series F units are only available to investors who participate in eligible wrap programs or flat fee accounts with their registered dealers that have entered into a Series F Agreement with BMO Investment Inc.

• Equity markets have had a tough start to the new year, mainly driven by inflation fears/rising interest rates and geopolitical tensions; however, the BMO Dividend Funds have performed well in mitigating downside risk. They are constructed to deliver solid exposure to equity growth, produce solid higher income streams, and manage risk, by investing in high-quality equities with a track record of sustainable dividends.
• We can see the impact of investing in sustainable dividend-growing companies above so far in 2022.

Conclusion

• Buoyed by improving economic conditions, loosening of pandemic-related regulatory restrictions, and improving corporate earnings, several companies have raised dividends recently, with several more expected to raise dividends in the coming months.
  • For example, within U.S. and Canada, we saw federally regulated financial institutions increase dividends. The dividends were meaningfully increased from anywhere between 10% to 30%.¹ In Europe, we saw similar trends as well.
• Sustainable dividend investing is a historically proven approach to effectively achieve growth and mitigate risks relative to the broad index.

This article was originally published in January of 2022 and updated in May of 2022.

¹ Bloomberg, BMO Asset Management, as of April 30, 2022.