With stocks so volatile, here‘s a dividend strategy that provides a nice income

(This is the second in a series about dividend stocks in today’s low interest-rate environment based on interviews with professional investors. The first piece included , editor of The Prudent Speculator.)

For investors who have been hungry for income, today’s low interest rates have erased many options from the menu.

That’s where Federated Investors’ Daniel Peris comes in.

Peris, head of the Strategic Value Dividend Team at Federated, takes a different approach, focusing on providing an increasing income stream to shareholders of three mutual funds he co-manages.

Those include the $9.5 billion Federated Strategic Value Dividend Fund , the $423 million Federated International Strategic Value Dividend Fund  and the Federated Global Strategic Value Dividend Fund , which is much smaller, with $1.6 million in total assets and was established in January 2017. Including private and institutional accounts and advisory relationships, Peris’ team manages about $30 billion.

The Federated Strategic Value Dividend Fund is focused on the U.S. market, with the Dow Jones U.S. Select Dividend Index  as a benchmark. The Federated International Strategic Value Dividend Fund is made up of non-U.S. stocks, and its benchmark is the MSCI World ex-U.S. High Dividend Yield Index. The Federated Global Strategic Value Dividend Fund, as its name implies, includes U.S. and non-U.S. stocks; its benchmark is the MSCI World High Dividend Yield Index.

Focusing on income

Peris said the main objective of the Federated Strategic Value Dividend Fund is to provide shareholders a monthly income stream, while also aiming for capital growth over the long term. An important goal of the fund is to increase the portfolio yield (before fees) by 4% to 5% a year, and Peris expects share-price appreciation to match dividend appreciation.

The 30-day SEC yield for the fund’s R6 shares (the share class with the lowest annual expense ratio of 0.79%) is 4.17%, however, Peris said the 30-day yield, which looks backwards, “is almost impossible to experience.”

It may be more reasonable to look at the fund’s weighted average dividend yield of 4.67% in the second quarter. The fund distributes all of its income, so it is not as simple as subtracting the 0.79% in annual expenses from the portfolio yield. The expenses come out of the fund’s total assets. If we were to subtract the annual expense ratio from the second-quarter portfolio yield, we would have a yield of 3.88%. That is an attractive yield in this environment, considering the yield on 10-year U.S. Treasury notes  is 1.53% and the yield on 30-year Treasury bonds  is 2.02%. (The weighted aggregate yield for the S&P 500 is 2.05%, according to FactSet.)

For the class R shares, dividends distributed during 2018 totaled 27 cents a share. If we divide this by the closing price of $6.15 on Dec. 29, 2017, we have a dividend yield of 4.39% for 2018.

Looking further back, annual dividend distributions for the Federated Strategy Value Dividend Fund’s Class R shares increased 8% in 2018, after increasing 9% in 2017. The Class R shares were launched in June 2016.

It is important to look at the annual distributions, because those include special dividends that can vary greatly by company, industry and even for the entire market from year to year. The fund’s institutional shares  have a longer track record (and a current annual expense ratio of 0.81%). Here are annual dividend distributions per share over the past five years, according to FactSet:

Year Dividends distributed per share Increase from previous year 2018 $0.27 8% 2017 $0.25 9% 2016 $0.23 0% 2015 $0.23 -4% 2014 $0.24 0% Source: FactSet Selecting stocks

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Peris said he and his team look for companies with “a clear path to dividend growth,” and try to avoid companies that may be likely to cut their dividend payouts.

Many managers will look for companies with ratios of dividends to free cash flow that aren’t very high, to be comfortable that there is headroom to increase dividends. But Peris said companies with high payout ratios are typically attractive to him, because “they have less cash available for buybacks.”

While being careful to emphasize that he wasn’t looking to “starve” companies of cash they need to reinvest in their businesses, Peris said, “once they have made all their relative investments, we are inclined to ask for the rest.”

“The U.S. stock market is set up completely differently, where free cash is spent on repurchases,” he said.

When asked about how he decides when to sell a stock, Peris said: “Over the past 10 years, the vast majority of exits has been companies whose price appreciation has been way ahead of the dividend increase rate.”

Top holdings

Here are the top 10 holdings (of 41) of the Federated Strategic Value Dividend Fund as of July 31:

Company Ticker Dividend yield Total return – 2019 through Aug. 23 Share of fund AT&T Inc.   5.86% 28.0% 6.1% Philip Morris International Inc. 5.61% 25.1% 5.6% Dominion Energy Inc. 4.83% 8.9% 4.5% AbbVie, Inc. 6.49% -25.5% 4.0% BP PLC ADR 6.74% -0.1% 4.0% Exxon Mobil Corp. 5.16% 2.5% 4.0% Coca-Cola Co. 2.98% 15.4% 4.0% Verizon Communications Inc. 4.31% 2.6% 3.8% Southern Company 4.30% 35.9% 3.7% Duke Energy Corp. 4.17% 8.5% 3.6% Sources: Federated Investors, FactSet

Here are the top 10 holdings (of 43) of the Federated International Strategic Value Dividend Fund as of July 31:

Company Ticker Dividend yield Total return – 2019 through Aug. 23 Share of fund BCE Inc. 5.17% 20.0% 5.1% National Grid PLC 5.55% 16.1% 4.8% Enbridge Inc. 6.84% 10.0% 4.3% Sanofi 4.00% 5.7% 4.0% Emera Inc. 4.18% 33.2% 3.9% BP p.l.c. 6.86% 3.0% 3.7% Zurich Insurance Group Ltd. 5.47% 25.6% 3.5% Canadian Imperial Bank of Commerce 5.76% 1.0% 3.4% TC Energy Corp. 4.66% 35.2% 3.4% Total SA 6.06% -3.2% 3.3% Sources: Federated Investors, FactSet Income and yield-to-cost

Rather than pointing out that a focus on total return may be best for long-term investors seeking growth, we have looked at income — and increasing income — in this article. Peris said it was “super important” for investors to understand yield-to-cost. If you buy shares of a company that later raises its dividend, the current yield may not increase if the shares have risen, but your yield, based on what you paid for your shares, will increase. The same will be true for a mutual fund that increases its dividend distributions.

An excellent example of how patience can pay off is provided by Southern Co. , the ninth-largest holding of the Federated Strategic Value Dividend Fund.

If you had purchased shares of Southern on Aug. 22, 2014, you would have paid $43.68 a share. The quarterly dividend at that time was $0.525 a share, for a yield of 4.81%. The share price on Aug. 23, 2019, was $57.68. The current quarterly dividend distribution rate for Southern is 62 cents a share. So the current yield has declined to 4.30%. If you didn’t reinvest the dividends, your yield-to-cost would have increased to 5.68%. That is an attractive yield in this environment, and in this case you would also have enjoyed capital appreciation of 32% over the five years.

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