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By Bailey McCann 

For the past decade, dividend stocks were a pretty simple play: stable stocks that you hold for building wealth or generating income in retirement.

But the math is beginning to change. For one thing, during times of economic downturns, as we're in now, companies consider changes to the dividend to keep cash on hand. At the same time, government loans designed to help companies during the pandemic lockdowns might also set limits on the dividends businesses can pay out in the future.

In this new environment, investors may need to rethink their approach to dividend stocks. Here are some things investors should consider.

1. Expect lower payouts

The stock market has bounced back from its plunge earlier this year, but not all dividends have. According to data from Janus Henderson, which tracks dividend stocks through its Global Dividend Index, more than half of the companies in the index canceled their dividends in the second quarter and an additional 25% lowered payouts. In its analysis of the companies in the index, Janus Henderson sees the firms' dividend payouts falling -- at best -- by 19%, making 2020 the worst year for dividends since the financial crisis.

Perhaps not surprisingly, dividend stocks have also lagged behind the market in 2020. The S&P Dividend Aristocrats Index, which tracks shares of companies that have consistently raised their dividends year over year, is down 4.6% for the year to date, compared with the S&P 500's 4.1% advance. Dividend stocks have been vulnerable to bigger selloffs this year as companies have announced the cuts to or suspensions of payouts; some funds are required to sell in the event of a negative change to the dividend. (The Dividend Aristocrats Index itself will look different at the start of 2021, as some constituent companies will be removed when the index does its yearly rebalance at the end of this year as a result of dividend cuts.)

Lower payouts will especially hurt investors who rely on dividend stocks for income in retirement. Companies typically pay out their dividends quarterly, so there will be a lag between any cuts or suspensions and reinstatements. This means if a company that cut its dividend earlier this year reinstates it now, investors aren't likely to see a payout until the fourth quarter or, in some cases, next year.

Investors in retirement will want to assess cash on hand to make sure they have enough for the remainder of this year and potentially set aside more cash for next year, so that they are less reliant on dividend payouts quarter to quarter.

2. Be wary of financing

Not all companies made cuts or suspended dividends this year, but there are times when maintaining a dividend isn't necessarily a sign of strength. Companies that borrowed to maintain their dividend during the drawdown in March and April or paid it from cash on hand despite limited revenue are on a riskier path. "Financing doesn't matter until it does," says Tony DeSpirito, portfolio manager of BlackRock Dividend Equity Fund (MDDVX).

According to Mr. DeSpirito, companies that add on debt in a drawdown, whether to pay dividends or cover other costs, typically emerge from the correction in a weaker position -- and could be forced to cut or suspend the dividend later on. "It may work short term, but if revenue growth doesn't come back, that's when you see all sorts of issues pop up," he says. "Financing a dividend is a big red flag for us."

For investors who have exposure to companies that took on debt during the first half of this year, now is the time to look for any signs of weakness and determine whether to stay or sell.

Companies that took government financing like the Paycheck Protection Program or disaster loans, or used the Main Street Lending Program, may also find themselves in exactly this position come next year if their businesses are still disrupted. These companies can't use the funds to finance a dividend directly, and provisions in government financing programs also prohibit stock buybacks. Companies that don't do buybacks but want to return money to investors will typically raise their dividends. This is a practice the government and lenders aren't likely to support, which means those companies may be looking at holding dividends flat or cutting them without a significant influx of revenue in 2021 or beyond.

Even in cases where revenue rebounds, provisions in loan agreements may mean that companies will have to keep dividends flat until loans are fully repaid, which could take years.

For dividend investors used to yearly increases in payouts, they may need to limit their exposure to otherwise strong companies if they can't afford to wait out loan-repayment plans.

3. Don't chase after yelds

Companies that pay dividends are typically mature companies, with limited competition and consistent revenue. But when uncertainty reigns, even the strongest companies can come under pressure. And in an era where there are few sources of investment income, dividend stocks are likely to gain in popularity and value even if they show signs of weakness. Against this backdrop, focusing on the sustainability of the dividend is important.

Some companies offering high dividends are in riskier industries or have overestimated growth. Energy investors, as well as those with exposure to travel and leisure companies, experienced this firsthand in the first quarter of this year.

"There are many examples of investors chasing high dividend yields only to lose money," says Andrew Mies, founder and chief investment officer at Wichita, Kan., financial adviser 6 Meridian. "You have to consider the sustainability of the dividend. If a company is paying $1 and making $4, that's probably pretty sustainable. If a company is paying $1 and making $2, that's a problem." For companies that have maintained a dividend this year, now is a good time for investors to examine whether they think it is sustainable going forward. If not, it may be a good time to sell high and take profits.

On the other hand, in the case of companies that cut dividends but are likely to reinstate and rebound, now may be the time investors can get in at a slight discount.

"Cuts aren't always permanent and in some cases can be a sign of strength," says Matthew Egenes, client portfolio manager at financial-advisory firm Barrow, Hanley, Mewhinney & Strauss. "If a company cuts a dividend instead of taking on debt, that's going to be better long term. We take it as an opportunity to look at a company and see what's going on." Barrow Hanley identifies value opportunities as the adviser for Transamerica Dividend Focused fund (TDFAX).

Dividend payers in sectors like consumer staples, financials and utilities, which have been relatively stable this year, are also emerging as stocks that investors are turning to for income because of the sustainability of their payouts despite uncertainty.

Ms. McCann is a writer in New York. She can be reached at reports@wsj.com.

(END) Dow Jones Newswires

October 04, 2020 20:49 ET (00:49 GMT)

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