Income Investing Takes Homework, Too

Equity-income investing can be highly rewarding, but it is not without its potential pitfalls. The rules of careful stock-picking still apply.      

Stocks that generate high income offer investors a welcome refuge in today’s stormy markets because they have the potential to preserve capital and to deliver at least some positive return. For many investors, a strategy that emphasizes such stocks beats trying to time the market’s low or dealing with stressful market swings.

But even in this relatively safe corner of the investment world, it’s still important to do your homework. Investing solely for the highest dividend yield or the biggest buyback program can backfire, sometimes badly. An unusually high dividend yield is often a sign of a company in trouble, and can presage a dividend cut.

Research conducted by my colleague John Phillips found that the quintile of global stocks that pays the highest dividend yields has outpaced the market since 1971—but the next-best quintile did even better (Display), and with materially less volatility. Why? There are generally fewer blowups in the second quintile than in the first.

Highest Yielding Stocks Aren't the Best PerformingBuybacks also have a strong history of rewarding shareholders. Since 1971, the quintile with the least net equity issuance (an indicator that a company is either buying back shares or issuing relatively few new ones) has strongly outperformed both the market and all other quintiles (Display). But companies that repurchase shares at prices above the fundamental value of their assets destroy value for shareholders—especially if they finance buybacks by taking on excessive debt.

Shareholder-Friendly Companies Are BestThis research suggests that it pays to study each company’s cash-returning potential on its own merits. You must analyze the sustainability of each company’s cash flows within the context of its business outlook, long-term capital reinvestment needs and debt burden.  

The popularity of equity income strategies over the past two years has pushed up valuations, but I still see substantial opportunity in these strategies. Corporate cash levels are still near all-time highs, and net debt is lower than at any time since the early 1980s. Yet buybacks and dividend payouts are still in the doldrums. In the US, dividend payouts are at an all-time low. But the pressure on companies to increase their cash giving continues to build, especially with short-term interest rates likely to stay near zero for some time.

Investors have paid the most for firms with the highest current dividend payouts—notably utilities, which posted the strongest total return gains of any US sector last year. But investors have been hesitant to do so for firms that have the capacity to be much more generous in the future. That’s why we’ve explicitly targeted our research to those cases where strong cash-return upside potential and attractive valuations intersect. We continue to take advantage of these opportunities across diverse sectors, such as technology, consumer cyclicals, materials and energy.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Sharon Fay is Head of Global Equities and John Phillips is a Senior Portfolio Manager, both at AllianceBernstein.

 

Sharon Fay

Sharon E. Fay was named Head of AB Equities in July 2010. She is responsible for overseeing the portfolio management and research activities relating to all growth and value investment portfolios. In addition, Fay serves as CIO of Global Value Equities, overseeing the portfolio management and research activities related to cross-border and non-US value investment portfolios. From 1999 to 2006, she was CIO of European and UK Value Equities, serving as co-CIO from 2003 to 2006 after being named CIO of Global Value Equities in 2003. From 1997 to 1999, Fay was CIO of Canadian Value Equities. Prior to that, she had been a senior portfolio manager of International Value Equities since 1995. Fay joined the firm in 1990 as a research analyst, subsequently launching Canadian Value, the firm’s first single-market service focused outside the US. She then went on to launch the company’s UK and European Equity services and build Bernstein’s London office, home of its first portfolio management and research team based outside the US. Fay holds a BA from Brown University and an MBA from Harvard Business School. She is a CFA charterholder. Location: New York

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