How to Build a Recession-Resistant Portfolio of Dividend Stocks

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Dividend stocks have a reputation for being boring, and investors often think that they are for widows, orphans, and retirees. That reputation is not entirely deserved. Even aggressive investors have a reasonable exposure to dividend stocks that provide stability to their portfolios during volatile times. A recession-resistant portfolio of dividend stocks can help you navigate a bear market with below-average risk.

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What are Dividends?

Companies distribute a portion of their profits to their shareholders, with payments called dividends. Newer companies are less prone to issue dividends, preferring to invest their profits in growth. Mature companies, which have more predictable cash flows and less space to grow their market share, are more likely to pay dividends.

Investors can make money from both stock appreciation and dividends. But note that although dividend stocks offer two sources of returns, they do not necessarily outperform growth stocks. During periods of aggressive growth, dividend stocks may not perform as well as high-growth stocks with exciting stories.

During market downturns, though, dividend-bearing stocks tend to outperform. Let’s look at why that is.

👉 For Example

Consider oil and gas giant ExxonMobil. Suppose you buy 10 shares for a total of $1,000.

The company is expected to pay a dividend of $3.52 per share in dividends this year, thanks to booming oil and gas prices. So, you will get a total dividend of $35.2 this year, implying a dividend yield of 3.7%.

The company will likely increase shareholder payouts as it expands its profit.

Remember, even if a company is paying handsome dividends this year, it may not necessarily continue to pay those dividends. The pandemic was a classic example of that. Many companies trimmed or completely suspended dividends to preserve cash for uncertainties.

Investors should focus on companies that have solid profitability and a track record of paying reliable dividends in the long term. And companies that have stable earnings, less volatile stock, and low-risk businesses are more likely to fit this criterion.

Pros & Cons of Dividend Investing

✔️ Pros

  • Regular passive income
  • Low-risk, less volatile stock
  • Peace of mind
  • Less correlation with broader markets

❌ Cons

  • Tax implications
  • Underperforms in bull markets

Dividend Investing Terminology

Let’s look at some key terms used by dividend investors.

Dividend Yield

Some investors focus on the absolute dividend amount. It’s better to look at dividend yield, which is the dividend as a percentage of the price you paid for the stock. Even if the price changes, your yield is still based on your purchase price.

👉 For Example

Mr. Smart finds PQR, a stock that costs $20 apiece and pays $1 in dividends. He is quite happy with the deal and is about to invest in PQR.

However, in a casual talk the next day around an office water cooler, his colleague Mr. Smarter mentions a stock XYZ that pays a dividend of $0.5 and costs $5 apiece. Jones is still happy that he will receive a higher dividend amount by investing in PQR, only to realize later that it’s the dividend yield that matters and not the amount.

That’s because the dividend yield of PQR is 5%, while the yield of XYZ is 10%. Assuming you invest the same amount of money, you’ll get a much higher percentage of your investment back with XYZ.

Higher yields are not always desirable. Extremely high yields may not be sustainable and may indicate a distressed company desperately trying to attract or retain investors.

Dividend yields are an important factor supporting the price of dividend stocks during downturns. If the dividend per share stays the same, the dividend yield goes up as the stock’s price falls.

Let’s say a stock worth $100 is paying a $3/share dividend every year. If the stock price falls to $60 and the dividend remains the same, the yield becomes 5%. As dividend yields rise, they draw in income-oriented investors, and their buying supports the price, limiting the downside.

Payout Ratio

Another important metric to consider is the payout ratio. It measures how much of the company’s profits are distributed as dividends in a particular period.

In the last 10 years, the S&P 500 had an average payout ratio of 30%. In comparison, the payout ratio of the utilities sector was around 70%.

Utilities are a special case. Because they are heavily regulated and their profits are essentially guaranteed, they can afford very high payout ratios. For any other company, a payout ratio of 70% would be quite risky: if profits drop the company might not be able to sustain the dividend.

Ex-Dividend Date

Ex-dividend date is an important date in the dividend calendar. It is the day before the record date when the company checks your name in its books to be eligible for dividends. So, investors must buy the stock a day prior to an ex-dividend date to get those dividends.

Dividend Kings and Dividend Aristocrats

Many investors seek out companies that consistently increase their dividends. Companies that have increased their dividend every year for a certain consecutive number of years are granted informal titles.

👑 Dividend Kings: Stocks that increase their dividends for 50 consecutive years.

🎩 Dividend Aristocrats: Stocks that increase their dividends for 25 consecutive years.

These stocks are among the most reliable dividend payers (though they may not have the highest yields), and are considered very safe investments, especially during downturns.

Dividends and Downturns

Dividend stocks are often considered “boring”. They tend to be large, well-established companies without astronomical growth rates or exciting stories. They often underperform during periods of aggressive expansion.

During a recession or a bear market dividend stocks come into their own. Their stability and high market shares give them resilience, and they are usually profitable enough to weather the storm. Their dividends rise as the stock price falls, drawing in income investors and effectively putting a floor under the stock price.

Dividend investing may not be the most aggressive investing style, but in some variants, it consistently outperforms major indices.

Companies that initiate and raise dividends have generated much larger returns than the S&P 500 for some time. Dividend growth investing – a strategy that focuses on companies with both growing earnings and growing dividends – has outperformed many more aggressive strategies over the long haul.

Returns of S&P 500 Index Stocks by Dividend Policy: Growth of $100 (1973-2021)
Source: Hartford Funds

Stocks to Consider

Now that we have covered the grander scheme of things, let’s look at some examples of stocks you might consider for your recession-resistant dividend portfolio.

1. A Classic Utility Bet

What makes a dividend stock safe and reliable?

Consider US utility Southern Company (NYSE:SO). It is the second-biggest electricity and natural gas company in the country, serving more than nine million customers. It has a long dividend payment history of 75 years and has increased its dividend in each of the last 21 consecutive years. Such a long dividend growth streak is noteworthy, especially during the challenges like the pandemic and the financial meltdown in 2008.

So, how did Southern Company manage to maintain its payout growth?

Utilities like Southern operate in a highly regulated environment and earn a stable rate of return no matter what the broader economy is doing. Plus, the demand for utility services does not change with macroeconomic conditions. So, be it the economic boom or a downturn, Southern Company has reported stable earnings growth for all these years, which ultimately facilitated stable dividends.

Southern Company stock currently trades at a dividend yield of 3.5%, in line with its peers. For the future as well, investors can expect a consistent increase in its payouts driven by steady earnings growth.

If you invested $1,000 in SO stock a decade back, the reserve would have grown to $2,700 today, including dividends. That indicates an annualized return of 10.5%, underperforming the S&P 500’s 13% return. SO’s relatively lower return is justified given its low-risk, less-volatile stock.

Southern Company Dividends

Even if an economic downturn occurs and hits broader markets, utilities like Southern Company will likely remain resilient. That’s mainly because its earnings are predictable.

You may not get rich overnight with utility stocks like Southern Company. However, if you are looking out for consistently growing passive income, recession resilience, and low risk, Southern Company is the type of stock that might appeal to you.

2. A Low-Risk Energy Midstream Giant

Like utilities, energy pipeline companies operate in low-risk, regulated business environments. An $88 billion Canada-based Enbridge is one classic example. It yields a juicy 6% and has increased its shareholder payouts for the last 27 consecutive years.

Enbridge is the biggest energy pipeline company in North America. It moves about 30% of the crude oil produced and 20% of the natural gas consumed in the US. Apart from an unparalleled network of pipelines, Enbridge generates its revenues from energy storage and renewable assets as well.

Being an energy infrastructure company, Enbridge has stable earnings growth, even when oil and gas prices are volatile. Its revenues and earnings are derived from long-term transport and storage contracts that yield consistent revenue regardless of the price of the end product, which make them relatively safe and predictable.

As the company expands its pipeline infrastructure, it will likely grow earnings and dividends in the future. The significance of energy pipelines will increase more going forward, given North America’s inadequate midstream infrastructure.

In 2022, Enbridge will pay annual dividends of CAD$3.44 per share. This marks a 3% increase compared to last year. Though a 3% increase looks insignificant, Enbridge has increased its dividends by a decent 10% CAGR in the last 27 years.

3. A Dividend King

Industrial conglomerate 3M (NYSE:MMM) is another reliable dividend-payer for income-seeking investors. It has paid dividends for more than 100 years and has increased them for the last 64 consecutive years. It paid a dividend of $5.92 per share last year, indicating a juicy yield of 4%.

3M is wildly popular for its swanky, colorful post-its, but the company is much more than that. It operates through four segments: Safety & Industrial, Transportation & Electronics, Healthcare, and Consumer. The Safety and industrial segment is the biggest revenue contributor and contributes 35% to the company’s topline. Transportation and Electronics provides 25%, while the Healthcare and consumer segments makes up the rest.

It should be noted that stable dividend-paying stocks may not be suitable for all types of investors. For example, though 3M has a super-long payout history, the stock has notably underperformed markets in the last several years. And that’s because its revenues and earnings have grown by a measly 1.5% and 3% CAGR in the last decade, respectively.

However, if you are looking for consistently growing dividends and are okay with lower appreciation potential, 3M should be on your watchlist.

4. Dividend ETFs

Some investors might not have time for researching dividend stocks. In that case, consider dividend ETFs (exchange-traded funds). These funds invest in a range of dividend stocks from various sectors. The risk gets diversified and an investor gets exposure to assorted industries.

For example, iShares Select Dividend ETF (DVY) offers diversified exposure to all cap equities and yields nearly 3%. It consists of more than 100 dividend-paying stocks in the US and UK. Utility stocks form 28% of the funds holdings and large-cap stocks form 74% of the fund. AltriaValero Energy, and IBM are the three top constituents and collectively form 6% of the fund.

Investing in dividend ETFs could be an intelligent move, mainly because of diversification. If one stock or sector is going through troubling times and decides to suspend dividends, the rest of the holdings will likely maintain or increase their payouts. However, there is a downside as well. There is an additional layer of fees in terms of an expense ratio. iShares Select Dividend ETF charges 0.39% per share.

The SPDR Portfolio S&P500 High Dividend ETF (SPDY) is another alternative you can consider. It has a dividend yield of close to 4% and a lower expense ratio of 0.07%. Valero EnergyBristol-Myers Squibb, and ExxonMobil are some of its top constituents.

Bottom line

Dividend stocks have a place in every portfolio, especially during uncertain economic times. Quality growth stocks may outperform and can create generate greater returns, but they can also be very unpredictable. We always remember the growth stocks that make it big, but it’s easy to forget that many disappear without a trace.

Recession-resistant dividend stocks will not generate exponential returns. That’s not what they’re for. But if you’re looking for a defensive portfolio that offers both returns and appreciation, assigning a portion of your assets to quality dividend stocks may be a good move.

Article by Vineet Kulkarni, FinMasters.

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