The S&P 500 is up almost 20% this year, yet dividend paying stocks are not participating in the rally. In this video, Portfolio Manager Drew Justman of Madison’s Dividend Income Fund explains why dividend stocks are underperforming and what it means for the relative opportunity moving forward.
Transcript
Christopher Aleman
Hello and welcome back to Madison’s video series of conversations with a PM. My name is Christopher Aleman, regional investment director from Madison Investments, and I support advisors in the Northeast. This series is designed to bring our portfolio managers in and discuss relevant topics that you and your clients are seeing recent headlines, stories that create uncertainty, opportunities that we are finding value in and potential challenges to be on the lookout for. So today I’m joined by Drew Justman, Portfolio Manager on the Madison dividend income, and Madison covered call strategies. Drew, thank you for joining me today.
Drew Justman
Hey, good morning, Chris. Nice to be with you.
Christopher Aleman
So let’s kick this off with the S&P 500 index. The S&P 500 is up almost 20% this year, yet dividend paying stocks are not really participating in this rally. Now I know that much of the market performance is driven by a few names, but I don’t want to talk about that right now. But I guess my first couple of questions are, have you ever seen anything like this? I mean, how would you describe what’s happening in the equity markets?
Drew Justman
Yeah, the first half of 2023 was certainly an unusual market environment, the market was up strongly. And as you noted, the S&P was up almost 20%, I think 17% through the first half of the year. And much of that was driven by multiple expansions where the market’s valuation expands, as opposed to earnings growth, specifically the S&P 500 ended 2022, trading around 16 and a half times forward earnings estimates. And today, it trades closer to 19 times. So it’s above its 15-year average of 17 times. And it’s been a very strong market environment for select sectors and a group of stocks. Most notably, technology, communication services, and consumer discretionary. Were the top performing sectors in the first half, many other sectors did not have such strong gains. And many of those sectors include dividend paying stocks.
Christopher Aleman
No, I think that’s really interesting, especially when we’re talking about earnings and the differences between the valuation, etc. So I want to stick with the s&p for a minute and I wanted to touch on valuation. So two-thirds of the overall performance of the S&P, as you mentioned in the second quarter was driven by seven stocks, The Magnificent Seven, whatever new term we’re throwing out there. But given that backdrop, are valuations in the broad, S&P rich and if so, are they reflective of the overall market? I mean, how do you value dividend stocks? How do you value dividend stocks in this environment?
Drew Justman
Yeah, so as I mentioned, the market’s valuation is above its 15-year average. And I was driven by specifically strong returns in technology, communication services, and consumer discretionary, dividend paying stocks, many high quality dividend paying stocks were actually down in the first half of the year, the interest rates are at higher levels, and that has pressured some dividend stocks. And then within the technology group, there are prospects for artificial intelligence that are really creating some market excitement among market participants. So it’s created an attractive situation for dividend stocks, and they’ve had an unusual relative underperformance versus the broad market and we think that’s creating an opportunity. We value dividend stocks by looking at the company’s dividend yield divided by the market’s dividend yield, and we use the S&P 500 as the broad market, we look at that ratio over a company’s history. When a company is trading at the high end of its relative yield historical range, that usually means its valuation is low, and there’s a good margin of safety within that stock. Conversely, if a stock is trading at the low end of its historical relative yield range, that valuation is high, and there’s not as much of a margin of safety. So dividend stocks in general right now are trading at very attractive relative yields. For example, the Madison dividend income fund is trading it has a yield of 3% at the end of the second quarter, and the S&P 500 yield was closer to one and a half percent. So we get two times the dividend yield compared to the S&P 500. And that is historically high. That’s the highest it’s been since we’ve been managing the strategy which dates back over a decade now. So it’s a very attractive time to buy dividend stocks or look to own dividend stocks following this historical period of underperformance.
Christopher Aleman
So I have one more question. And I think, given the backdrop of the markets that you’ve already laid out for us why you feel dividend strategies are kind of, I guess, in a sweet spot. Let’s focus back on Madison’s dividend income strategy. So in addition to dividend yield and valuations, I think we’ve touched on that a little bit. What other fundamental qualities? I mean, what other parts of your process are you looking for, when evaluating companies to include in the strategy that we need to make sure the investors understand?
Drew Justman
Yeah, so the Madison dividend income fund is a conservatively managed equity strategy. We want to own a high quality portfolio of above average dividend stocks, trading at below average valuations. And we try to define high quality objectively. For example, Standard and Poor’s gives us financial strength ratings for companies. 86% of the fund holdings in the dividend income fund are rated A-minus or better by Standard and Poor’s and that compares to just 32% for the s&p 500. So based on financial strength, we think we’re objectively much higher. And that financial strength is important because in market corrections and bear markets, stocks with the strongest balance sheets tend to hold up the best. And that’s really what we focus a lot on is protecting capital on the downside. We’re willing to leg in really strong up markets as long as we can protect capital in down markets. And by doing that by limiting drawdowns in tough market environments. That’s how we try to generate attractive long term returns. In addition to financial strength, in addition to financial strength, we also look at a company’s sustainable competitive advantage. Morningstar provides moat ratings for companies and wide moat is the highest rating they award 67% of fund holdings are rated wide moat by Morningstar compared to just 27% for the s&p 500. So based on that measure, were objectively higher quality. And so that’s really we want to find stocks with an above average dividend yield, and we defined above average is it has to be one time 1.1 times the s&p 500 dividend yield at the time of purchase. And then we want to have those stocks that have an above average dividend yield, they have to have a strong balance sheet, as I mentioned, by our my, our financial strength ratings, and we want them to have a sustainable, sustainable competitive advantage. And then the last thing we look at, is we really want to see we have an emphasis on dividend growth. So as I mentioned, our companies have grown their dividends 8% over the last year on average. And so we want to find companies that have a good historical record of consistently growing their dividends. So we want an above average dividend yield, financial strength, sustainable competitive advantage, and good dividend growth. And so we construct a portfolio of 35 to 50 stocks right now. It’s it’s 40 stocks, and we try to just invest conservatively over the long term in a tax efficient way.
Christopher Aleman
Well, I think you put a nice bow on that wrapping it up. I think focusing on those four characteristics I think is very important given the landscape that we’re in the uncertainty etcetera, fears that we’re now seeing And so I think that wraps it up. So Drew, thank you for taking the time to speak with me today and give a little bit more insight into the dividend income world.
Drew Justman
Yeah, thank you. It was nice speaking with you. Look forward to doing it again soon.
Drew Justman, Portfolio Manager on the Madison dividend income and Madison covered call strategies. To see more conversations with a PM or to learn more about Madison’s suite of strategies, please visit Madisoninvestments.com or reach out to the regional director in your area. Thank you and take care.
Christopher Aleman
Drew Justman, Portfolio Manager on the Madison dividend income and Madison covered call strategies. To see more conversations with a PM or to learn more about Madison’s suite of strategies, please visit Madisoninvestments.com or reach out to the regional director in your area. Thank you and take care.
Disclosures
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An investment in the Dividend Income fund is subject to risk and there can be no assurance the fund will achieve its investment objective. The risks associated with an investment in the fund can increase during times of significant market volatility. The principal risks of investing in the fund include: equity risk, growth and value investing risk, special risks associated with dividend paying stocks, option risk, interest rate risk, capital gain realization risks to taxpaying shareholders, and foreign security and emerging market risk. More detailed information regarding these risks can be found in the fund’s prospectus.
An investment in the Covered Call and Equity Income Fund is subject to risk and there can be no assurance the Fund will achieve its investment objective. The risks associated with an investment in the Fund can increase during times of significant market volatility. The principal risks of investing in the Fund include option risk, tax risk, derivatives risk, concentration risk, equity risk, mid cap risk, and market risk.
The Funds’ investment strategy reflects Madison’s general “Participate and Protect®” investment philosophy. Madison’s expectation is that investors in the Fund will participate near fully in market appreciation during bull markets and experience something less than full participation during bear markets compared with investors in portfolios holding more speculative and volatile securities. Therefore, the Fund’s investment philosophy is intended to represent a conservative investment strategy. There is no assurance that Madison’s expectations regarding this investment strategy will be realized.
As of June 30, 2023, the Dividend Income Fund yield is 3.1%. Dividend Yield is the portfolio’s weighted average of the underlying fund holdings and not the yield of the fund.
As of June 30, 2023, the Dividend Income Fund 30 Day SEC Yield for Class Y shares is 2.0%. The 30-day SEC Yield is a standardized formula designed to approximate the Fund’s annualized hypothetical current income from securities less expenses for the 30 day-period ended 12/31/20 and that date’s maximum offering price. If fees had not been waived and/or expenses reimbursed, the SEC yields would have been lower.
The Morningstar Economic Moat Rating represents a company’s sustainable competitive advantage. Morningstar has identified five sources of economic moats: intangible assets, switching costs, network effect, cost advantage, and efficient scale.
Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only, and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance.
The S&P 500® is an unmanaged index of large companies and is widely regarded as a standard for measuring large-cap and mid-cap U.S. stock-market performance. Results assume the reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index.