Picking the Dividend Stocks in the Face of High-Interest Rate Environment

Yuxiao YangThis “Picking the Dividend Stocks in the Face of High-Interest Rate Environment” article was written by Yuxiao Yang – Financial Analyst at I Know First.

Highlights

  • In practice, the assumption that dividend stocks are less sensitive to interest rates because the duration of their cash flows is shorter than for non-dividend payers can be violated.
  • Most of the biggest dividend ETFs provided negative returns in the first half of 2022 although they outperformed the broader market on the whole.
  • I Know First provides the Dividend Stocks package to help our clients to select the most promising dividend stocks.
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Overview

Dividend stocks are stocks that pay out regular dividends to their shareholders, usually in the form of cash payments. Dividends calculate from after-tax profits and represent a portion of company profits. Hence, an increase in dividend payments sends a positive signal of management’s confidence in the company’s prospects to current shareholders and potential investors, which would attract more investors.

When a company is performing well, having a healthy financial position, with a substantial income and stable cash flow, it means that there will be more disposable income to return to investors. Hence, the possibility of a high dividend from the company will increase. On the other hand, depending on the company’s growth strategy, if the company doesn’t have some expansion plans in the short run, it is possible to leave a larger portion of its profits to be returned to investors by dividends.

Dividend Stocks in Unfavorable Economic Environment

The traditional view in finance is that stocks that pay dividends are less sensitive to interest rates because the duration of their cash flows is shorter than for non-dividend payers. By paying dividends, a firm provides cash flow sooner to investors than one that only pays cash when the stock is sold; hence, the duration is shorter. High-growth firms tend to have lower dividend payouts but higher future growth rates. That skews the distribution of their cash flows toward the most distant future. In contrast, firms with higher dividend payouts tend to have lower retention ratios and lower future growth rates. Thus, the timing of their cash flows is relatively sooner. As a result, a valuation model predicts that duration tends to be higher for stocks with lower dividend payouts. Thus, we should expect that dividend-paying stocks, especially those paying relatively high dividends, will be less sensitive to interest rate risk.

On the other hand, when interest rates rise, investors can expect that industries and companies that heavily rely on debt resources will experience a plummet in profit as borrowing costs rise, which means leaving them with less money to pay dividends and return to investors. Companies are reluctant to distribute higher dividends if they face high uncertainty and may have to reduce future dividend payments due to lower earnings. This leads to dividends being negatively related to firms’ cash-flow risks. If stocks with higher dividends tend to have lower cash-flow risk, then their sensitivity to interest rate changes will be relatively greater.

The Mood in the ETF Industry

Most equity-income ETFs started the year with negative returns as major U.S. stock indexes fell into the bear market territory. At the same time, dividend ETFs got a better performance as net buying or inflows of almost $45bn. Most of the biggest dividend ETFs outperformed the broader market although they provided negative returns.

The ProShares S&P 500 Dividend Aristocrats ETF (ticker: NOBL) outperformed the S&P 500 and returned a negative 12% in the first half of the year, compared with a negative 20% return for the S&P 500. This ETF tracks an index of stocks that have increased dividends for at least 25 consecutive years, including 3M (MMM), Target (TGT), and Johnson & Johnson (JNJ).

Another ETF also had a relatively strong first-half performance was the WisdomTree U.S. High Dividend ETF (DHS), which returned about 1%. One factor contributing to its positive return is the heavy weight of energy stocks. Also, some small ETFs focused on energy infrastructure including VanEck Energy Income ETF (EINC) had about $31 million in net assets as of June 30 and had a strong performance to return of about 10.2 percent.

Investment Smart in Dividend Stocks with AI

In theory, dividend stocks have advantages compared with other stocks in the period of increasing interest rates, which in turn does not protect them from losses at all. There are a set of factors in investment in dividend stocks from debt ratio to economic sectors that impact the final investment results. I Know First provides the Dividend Stocks package to help our clients find the most promising investment opportunities (you can access our packages here). Below you can see the investment result of our Dividend Stocks package which was recommended to our clients on July 18, 2022.

Package Name: Dividend Stocks Forecast
Recommended Positions: Long
Forecast Length: 1 Month (7/18/22 – 8/18/22)
I Know First Average: 18.09%

Dividend Stocks
Dividend Stocks chart

In this 1-Month forecast for the Dividend Stocks Forecast Package, there were many high-performing trades and the algorithm correctly predicted 10 out of 10 trades. APPS was the top-performing prediction with a return of 41.5%. The suggested trades for PYPL and DE also had notable 1 Month yields of 35.11% and 23.61%, respectively. With these notable trade returns, the package registered an average return of 18.09% compared to the S&P 500’s return of 10.89% for the same period.

I Know First's algorithm

I Know First is one leading company that has been effectively using machine learning and AI-based algorithms to provide daily forecasts and facilitate trading for over 10,500 financial instruments. More importantly, I Know First’s algorithm can fulfill the idea of discovering “fractals” and patterns using a more accurate way through AI and machine learning without involving any human judgments. The algorithms can present historical price patterns based on the data inputs, testing the performance on years of market data, and validating them on the most recent data to prevent overfitting. If an input does not improve the model, it is “rejected”, and another input can be submitted. I Know First provides different forecast packages based on the AI algorithm which allows us to select the most promising stocks (you can access them here).

Conclusion

Traditionally we assume that stocks that pay dividends are less sensitive to interest rates because the duration of their cash flows is shorter than for non-dividend payers. However, in practice, this assumption can be violated. The environment of increasing interest rates has a negative impact on all equities in general, and we noticed that most of the biggest dividend ETFs provided negative returns in the first half of 2022 although they outperformed the broader market on the whole. I Know First provides the Dividend Stocks package to help our clients to select the most promising dividend stocks in the current macroeconomic environment.

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Please note-for trading decisions and use the most recent forecast.