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Perhaps is the old saying “there's no such thing as a free lunch” more applicable than in financial markets. When used in financial parlance, that phrase essentially means there are always trade-offs.
Fertile territory for those trade-offs is the quality factor. Quality stocks, regardless of the sector they hail from, offer an array of benefits, including strong balance sheets, investment-grade credit ratings, increased propensity for shareholder rewards and reduced volatility.
The trade-off is that those traits usually don't come cheap. That's often the case with many quality stocks, particularly those with impressive histories of raising their dividends. In exchange for that steadily rising income, which often facilitates reduced volatility, clients usually have to pay up for those privileges.
Owing to the long-term advantages and durability of quality, it's usually worth paying up. For advisors and their clients, the good news is they don't have to do that today and it's possible to access dividend durability without being forced to embrace extravagant valuations.
Aristocracy at Affordable Prices
Advisors looking for deals on reliable dividend stocks will find an ally in the widely followed S&P 500 Dividend Aristocrats Index. Among dividend gauges, the aristocrats is a popular one because it's entry requirement is strict – a minimum payout increase streak of 25 years is the threshold for admittance. That's one way of ensuring quality, but there's an element of value to the index that's particularly useful at a time of stellar earnings growth.
“At some point, today’s lofty earnings growth numbers will moderate. Some companies—perhaps even some of the largest market cap names—are likely to miss on earnings or at least disappoint,” says ProShares Senior Investment Strategist Kieran Kirwan. “While not the current situation, a potential scenario of weakening fundamentals combined with expensive valuations is probably not a good recipe for strong stock returns.”
Confirming its cyclical value traits, the S&P 500 Dividend Aristocrats Index allocates nearly 36% of its roster to industrial and financial services stocks. While those groups are admirable performers to this point in 2021 and dividend growth is improving, the aristocrats aren't sporting excessive valuations. In fact, they're cheap.
“The Aristocrats are also trading at the cheapest valuation levels relative to the S&P 500 in over a decade. While investors often pay a premium for quality stocks like the Aristocrats, causing them to trade at higher valuation levels when compared to the S&P 500, today’s situation is much different,” notes Kirwan.
Dividend Nobility Comes Cheap
In plain terms, it's accurate to say high-quality dividend stocks, often a favored destination for many clients, are inexpensive. However, that explanation can also be quantified with hard data.
“Relative to the S&P 500, the Aristocrats currently trade at roughly 80% of the market’s P/E valuation,” according to Kirwan. “This is the cheapest level the Aristocrats have traded since March 31, 2010. The Aristocrats went on to outperform the S&P 500 over the subsequent 1-, 3-, and 5-year periods, indicating that today’s margin of safety may be an opportune entry point.”
The benefits for the dividend aristocrats don't end there. Actually, this long-term strategy is a relevant near-term consideration because as the business cycle moves along, the low-quality value names that led late last year and in the early stages of 2021 could fall out of favor, paving the way of dividend quality stocks to shine.
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