Investing in Dividend Stocks: Strategies for 2025 and Beyond

Susan Dziubinski: Hello, and welcome to a special edition of The Morning Filter. I’m Susan Dziubinski with Morningstar. Today’s program is all about dividend stocks. I’m joined today by a special guest, Dan Lefkovitz. Dan is a strategist with Morningstar Indexes, a columnist with Morningstar.com, and the co-host of The Long View podcast. Dan and I are going to talk about how dividend stocks performed in 2024 and why, and what might be in store for dividend stocks in 2025 and beyond. And we’ll toss in a few undervalued dividend stocks at the end of the show for good measure.

But before we begin our conversation, a programming note. Morningstar chief US market strategist Dave Sekera and I will be back with a brand-new episode of The Morning Filter on Monday, Jan. 6. During the show, we’ll discuss Dave’s 2025 stock market outlook and get a handful of stock picks from him to kick off the new year. You won’t want to miss it.

Dan, thank you so much for being here, and Happy Holidays.

Dan Lefkovitz: Happy Holidays. Great to be with you, Susan.

Dziubinski: Let’s talk a little bit about the performance of dividend stocks in 2024. We are taping this in the middle of December, so things may change a little bit by the end of the year but probably not by much. How did dividend stocks perform in comparison with, say, the broader market in general during the year?

Lefkovitz: As a group, dividend stocks underperformed the broad US equity market. As you know, Susan, we have a lot of different dividend indexes at Morningstar, representing different flavors of dividend investing, different screens, but none of them kept up with the broad US equity market. It was a really big up year for US stocks. The Morningstar US Market Index is up nearly 30% as of this conversation; the dividend index is up around 20%, high teens, which is great in absolute terms, but in relative terms, they’ve lagged. I just want to mention two interesting observations. One, interest rates have come down this year, yet dividend-paying stocks have underperformed. There’s this conventional wisdom that we’ve talked about in the past that falling rates are good for dividend payers and rising rates are bad for dividend payers, yet dividend stocks have underperformed in a falling rate environment. Second, outside of the US, dividend stocks are a little bit ahead of the broad market. We can table those, but I just thought they’re interesting to note.

Dziubinski: Those are interesting observations. Unpack a little bit about the whys behind the performance of why didn’t dividend stocks, in general, keep up with the market, especially since rates were falling for part of the year, as you pointed out.

Lefkovitz: I’m going to use the Morningstar US High Dividend Yield Index, which I consider dividend beta. It is the higher-yielding half of the US equity market, and it’s an index that’s weighted by market cap. The main reason it underperformed was very simple. It was below market exposure to technology. Technology was not the best-performing sector, but close, and it’s a big, big chunk of the market now. It’s 31% of our Morningstar US Market Index. Our dividend index only has 14% of its weight in technology stocks. Nvidia NVDA did great up over 180% as of this conversation. Now Nvidia does pay a dividend, but it’s a low-yielding stock. It’s not in the dividend index. That was a big detractor from a performance attribution perspective. Some other names like Amazon.com AMZN and Meta META, which are not in the dividend index, did really well. It was just hard to keep up when you don’t own some of those top performers.

Dziubinski: Sure. Now that being said, we did have some dividend-rich sectors that did quite well in 2024, right?

Lefkovitz: Yes, absolutely. Two that I’d note are financial services and utilities. Those are both sectors that are overexposures for the dividend index, overweight. Financial services had a really strong year. Banks did really well. There was a big postelection surge, anticipation of lighter regulation. There’s also yield-curve steepening, which is good for banks because it increases that spread between the deposit rates and the lending rates. Banks did do really well. Utilities did really well. That was partially an AI story similar to Nvidia. AI is very power-hungry, so processing artificial intelligence demands a lot from utilities. So, rising demand for power has boosted utilities. Cryptocurrency mining is another driver for utilities. Utilities did have a strong year and they are dividend-rich, but the overweight exposures in those two sectors were not enough to counteract the underweight exposure to technology.

Dziubinski: Then that wasn’t really also enough to compensate for the underperformance of a couple of other dividend-rich sectors that didn’t do as well.

Lefkovitz: That’s very important. That’s another factor. Energy. Energy was a big overweight for our dividend index. The energy sector did not do well this year. Oil prices fell and that ate into the margins for energy stocks in the dividend-paying section of the market. Another one was healthcare. Healthcare is a dividend-rich sector these days. Overweight exposure did not do well. Healthcare is a sector that lagged postelection. There are a lot of worries about policy changes and such. Real estate is another one. It’s a small section of the overall market, but it’s a dividend-rich sector that underperformed in 2024.

Dziubinski: In many ways, though, 2024 was a significant year for dividends because we saw a couple of really high-profile companies come out and say for the first time, “Hey, we’re going to pay a dividend.” So, run down some of those companies and what they’re actually offering.

Lefkovitz: In the first quarter, we had dividend initiations for Meta, which is the parent company of Facebook, Alphabet GOOG, the parent company of Google, Salesforce CRM, and Booking.com BKNG. All of them announced that they would pay a dividend for the first time. And then we had Nvidia raise its dividend 150%. For all of these companies, the market interpreted this as a sign that they are really solid and established, confident in their future cash flows, and that they can commit to quarterly payments to shareholders. And if you look at the top 10 largest companies in the US stock market now, only Amazon.com and Berkshire Hathaway BRK.B stand out as nonpayers.

Dziubinski: Despite this news, though, buybacks still remained more popular with companies as the way to return excess cash to shareholders. Why do you think that is?

Lefkovitz: Thanks for killing the vibe, Susan. Yes. So, all of those companies that I mentioned—the initiators, Nvidia—they’re all spending more money, more cash in 2024 on share repurchases than they are on dividends. You know, share repurchases, this is a long-running trend. Share repurchases have become really popular. There’s an expression that dividends are like marriage, and share buybacks are like dating. They’re more flexible. Companies can conduct them opportunistically when they have excess cash on hand or when their shares are undervalued, hopefully. Whereas the dividend is a commitment, and if you withdraw it or lower it, it’s going to be punished by the market.

Dziubinski: Given the flexibility that buybacks do kind of afford companies, do you expect this to be a trend that’s going to continue that companies are going to tend to favor buybacks over paying dividends?

Lefkovitz: Most likely, unless there’s some kind of major structural shift. Buybacks are cyclical in nature. A colleague of mine on Morningstar Indexes, Aniket Gor, has done some research where he’s looked at aggregate sort of market-level buyback dollars versus dividend dollars. Over the past 15 years, there were only two calendar years in which dividends have exceeded buybacks. They were in 2009 and 2020. Why are those interesting, remarkable years? 2009 was during the financial crisis, and 2020 was during the pandemic. So, the economy was down, companies were feeling nervous, wanted to retain cash as opposed to spending it on buybacks, but wanted to maintain their dividend payments if they could. In down years for the economy, it wouldn’t be surprising to see buybacks come down, but like I said, I think it would take more of a structural shift for dividends to exceed buybacks. In addition to that flexibility, there are also tax advantages to the buyback versus the dividend because shareholders who aren’t selling their shares in a buyback situation aren’t taxed.

Dziubinski: All right. Gaze into your crystal ball, Dan, because, of course, you must have one, would you expect the fortunes to change for dividend investors in the next few years given the trend toward probably buybacks continuing to outpace dividends and just what we’ve seen in the market with dividend stocks during the past couple of years?

Lefkovitz: They certainly could. It really depends on market dynamics. As you’ve often reminded me, Susan, sector is so important, and depending on the performance of dividend-rich sectors, if technology underperforms, that might favor dividend-rich sectors. And you don’t have to go too far back into history to see a market when dividend-paying stocks outperformed. In 2022, some of our dividend indexes were actually in positive territory even when the overall equity market was down. So, 2022 was when inflation was a real problem. Interest-rate hikes were very aggressive. We had the Russian invasion of Ukraine. Energy was the best-performing sector of the equity market in 2022. That helped the dividend indexes and the dividend-paying section of the market. Defensive sectors that year performed relatively well—healthcare, consumer staples. Technology was the worst-performing sector of the market. So, that was a year when dynamics really favored the dividend section of the market, and market dynamics are constantly in flux and constantly changeable. It’s not hard to envision scenarios in which dividend payers outperform.

Dziubinski: Dan, on a recent episode of your podcast The Long View, you spoke with Daniel Peris, and he’s a historian, a fund manager, and the author of a book called The Ownership Dividend. And now, Peris thinks that there’s a paradigm shift that could happen for dividend payers. Talk a little bit about that.

Lefkovitz: This is really interesting. As you said, he’s a historian, and he chronicles the sort of centuries-old, tangible cash relationship, he calls it, between shareholders and businesses that the dividend kind of represents. The cash nexus, if you will. And he feels like we could be poised for a sort of return of the ascendancy of the dividend versus the buyback for several reasons. The first being interest rates. We have had some interest-rate cuts this year, and there are more that are being anticipated by the market. But I don’t think anyone’s predicting that we’re going back to the zero-interest-rate regime that prevailed after the financial crisis or after the pandemic. And higher interest rates do mean more competition in the form of cash yields and bond yields for dividend payers. The primacy of Silicon Valley technology-oriented companies has been bad for dividends because they generally have not been very generous with returning cash to shareholders in the form of dividend payments. We talked about changing market dynamics that could elevate more dividend-rich sectors. He also talks about geopolitics and sustainable investing as factors that could elevate the dividend. I also wonder if a more sort-of subdued return environment, if returns aren’t 30%, 25% like we’ve been seeing recently, where reinvested dividends are a bigger chunk of the overall total return that you get from equities might make them sort of more important and might put pressure on companies to elevate their dividends.

Dziubinski: That’s interesting. Let’s wrap up with some dividend stock ideas for investors to research further. You’ve brought us a few reasonably priced names from the Morningstar Dividend Yield Focus Index. Why that index in particular?

Lefkovitz: Dividend Yield Focus is one of our many dividend indexes at Morningstar, we built it in 2010 or 2011. It is, as the name would imply, a compact number of securities, 75 US stocks that are high-yielding. It uses two screens that are forward-looking in nature that try to identify companies that are really durable and will be able to sustain their payouts going forward. It screens on the economic moat rating. So, companies have to have a competitive advantage that will allow them to sustain profitability. Dividends come from the profits. And it also looks at financial health, so balance-sheet strength. Will the company have the wherewithal, the financial wherewithal to maintain its dividend going forward?

Dziubinski: Dan, we have a market that, again, as of the time we’re typing, this is pretty fairly priced today. And it seems like a lot of these stocks that are actually in the index that you’re talking about are also very fairly priced today. What’s the most undervalued stock in the index?

Lefkovitz: Dow Chemical DOW is the most undervalued stock when we look at the Morningstar equity analysts’ fair value estimate relative to share price. Seth Goldstein, who’s the analyst who covers this one, says that Dow is well-positioned for profit recovery as demand returns. It’s one of the largest chemical companies in the world. And our equity research team feels like its share price is not reflecting its prospects.

Dziubinski: Then we also have energy and healthcare, two sectors, which as you mentioned, in aggregate, they underperformed. So, they still look somewhat undervalued to Morningstar. Any undervalued stocks from the index, from these two sectors that Morningstar thinks are kind of attractive?

Lefkovitz: There are a number of energy companies that our analyst team feels are undervalued relative to their share price currently. Exxon XOM, Chevron CVX, and ConocoPhillips COP are all trading below their fair values.

Dziubinski: How about from healthcare?

Lefkovitz: Healthcare. I mentioned two names that start with an “m,” Medtronic MDT and Merck MRK. Medtronic is a device maker. Our analyst Debbie Wong says that Medtronic is beginning to reap the rewards of innovation. And then Merck, of course, is in the pharmaceutical space, and it’s got a great lineup of drugs, a strong pipeline, according to our research team. It has underperformed this year, but the research team thinks that its prospects going forward are attractive.

Dziubinski: And then lastly, are there any other stocks in the index apart from those sectors that sort of stand out to you?

Lefkovitz: Consumer staples, consumer defensive is another sector that I’ll mention. An interesting pair there, General Mills GIS and Pepsi PEP. And our analysts think that both of these companies have strong growth prospects, a strong product portfolio that’s being sort of underappreciated by the market.

Dziubinski: Well, Dan, it’s been great having you here as a special guest on The Morning Filter. Always great talking to you.

Lefkovitz: Thanks so much for having me, Susan.

Dziubinski: Viewers who’d like more information about any of the stocks we talked about today can visit Morningstar.com for more details. Be sure to join Dave Sekera and I for The Morning Filter on Monday, Jan. 6 at 9 a.m. Eastern, 8 a.m. Central. In the meantime, please like this video, subscribe to Morningstar’s channel, and enjoy the holidays.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

Source link