With the second quarter earnings cycle underway the question arises, what sectors should dividend growth investors be targeting? Growth in the second quarter is expected to be negative, estimates for future quarters has fallen and there is a risk the earnings recession that began in the first quarter could extend itself to three quarters.
My criteria for this analysis is simple: which sectors have the best outlook for growth this quarter, the clearest outlook for future earnings growth, and an expectation for earnings growth acceleration next year based on data compiled by and from FactSet Insight.
The impact of tariffs has had a terrible impact on earnings potential and nowhere is that more apparent than with companies whose revenue comes from abroad. During the first quarter cycle, S&P 500 (SPY) companies with more than 50% of their revenues from abroad saw their EPS fall double digits while those with most of their revenue from domestic sources saw their EPS increase.
While the trajectory of earnings growth is positive for the next six quarters, consensus estimates are falling and that is a weight that will keep stock market valuations in check. This makes dividends even more attractive as they may be the only positive returns investors get over the next few months.
From the technical perspective, an extreme bearish peak in MACD set last December and a wicked divergence in the same, coincident with the new all-time S&P 500 high, suggests the market will retest the December lows before too long.
Companies with shrinking earnings are more likely to decrease their distributions. That means choosing companies with domestic revenue sources is ultra-important for dividend and dividend-growth investors. It's not that companies with foreign-based revenue streams can't or won't raise their distributions, it means they aren't the best choices for investors looking for earnings-driven capital gains, dividends, and dividend growth like I am.
On a sector basis, the three that stand out are Real Estate (XLRE), Utilities (XLU), and Healthcare (XLV) sectors. These sectors are expected to produce positive EPS growth this quarter and have a clear path to future earnings growth, this year and next.
There are two other reasons that make these sectors of particular interest to me. The first is that they are either U.S.-centric in their business or it is very easy to find U.S.-centric businesses within them.
The second reason that helps make these sectors so attractive now is their real-asset appeal. Real assets (infrastructure, real estate, natural resources) continue to gain attention among investors for a number of reasons that I find compelling in today's market environment.
Larry Antonatos and Craig Noble, fund managers at Brookfield's Public Securities group (INF) (RA) (CEN), lay out a very good investment case for real assets that I've bought into. First and foremost is the growing global need for infrastructure spending. This need is driven by a rapidly growing, modernizing, and urbanizing global population. Real asset companies' revenue streams are pegged to the dollar/inflation providing a hedge within a portfolio, they are also protected by barriers-to-entry that protect and guarantee revenue streams long into the future.
The most important reason real assets are attractive today is the rate of returns that can be found within the asset class. The ten-year treasury is stabilizing after its recent fall but at a multi-year low 2.0%, the average S&P 500 dividend yield is sub-2.0%. Investors looking for stable income from assets with better risk-adjusted returns than the broader market can find 6%-12% returns in real assets.
Looking forward, these three sectors are expected to see their EPS growth accelerate (Real Estate and Healthcare) or hold steady (Utilities) which helps assure future dividend payments and dividend growth. They are not going to be the strongest earnings growers next year, far from it, but the sectors that will face significant headwinds to that growth.
The Consumer Discretionary (XLY) and Industrial Sectors (XLI) should see EPS growth approach 13% next year. That's about double the expectation for the Utilities and Real Estate sectors, 50% greater than the Healthcare sector, but estimates for this quarter have been falling sharply. Both the Discretionary and Industrial sectors are looking at negative growth for the 2nd quarter and at risk for sell-off. I think there will be a better time to refocus on those sectors later this year.
The Financials (XLF) sector is most likely this year's strongest EPS grower. The consensus stands at 6.9% now and growth will continue next year but there are two caveats. The first is that growth isn't going to expand appreciably, from 6.9% to about 8.30%, the second is that the Financials will be an index laggard in 2020. Aside from the sluggishness of global GDP expectations, the banks are looking at another dip in interest rates that will cut into profitability.
I'm not calling the Financials a bad investment, just a poor choice for dividend growth investors. Besides, the sector just issued a round of dividend increases and buybacks following the Fed Stress Tests. It'll be another year before they do it again, and there are better sectors to target until then.
The Materials (XLB) and Information Technology (XLK) sectors will be this quarter's worst performers, and both are expected to post double-digit earnings declines. They have also seen sharp downward revisions and both are exposed to global markets in different ways. These sectors are also expected to post negative growth for the year which by itself is enough for me to look elsewhere. Looking to next year, both these sectors are expected to post sharp, market-leading rebounds, so may present buying opportunities later this year.
The Consumer Staples (XLP) sector is another that might be doing better if not for the appeal of other sectors. This quarter it is looking at negative EPS growth which is a definite detractor for me, this year and next year it will be the lagging sector in terms of growth.
The Communications sector (XLC) may be a good choice but I'm skipping it this quarter. It is looking at positive growth this quarter, this year, and next. Growth is expected to accelerate this year and next. The sector may be a market leader next year. The reason I'm skipping is that it posted a big miss in the first quarter. The consensus was -2.0%, the reality was more than -5.0%. If the sector misses by 3.0% again it will post negative results this quarter and call forward outlook into question.
The Energy sector (XLE) is expected to post negative growth this year but robust double-digit growth next year. The earnings outlook for the sector is supported by oil prices which are in turn supported by OPEC+ scheme to tighten the energy market. The sector is expected to produce some robust dividend increases as well but I'm still skipping. The energy sector doesn't have a good history of dividend growth, earnings are dependent on oil prices and demand, and distributions could be cut the following year. Not a great choice for someone looking for sustained, long-term dividend increases like I am.
The Healthcare sector is my top pick from the earnings growth perspective but it has some drawbacks on the dividend side of the coin. In terms of earnings growth, it is expected to produce the second strongest growth this cycle, have that growth accelerate more than double by the end of the year, and then double again next year. The problem is that the dividend for the XLU Healthcare SPDR is pathetic, less than the broad market average, which means investors will have to pick and choose individual stocks for best effect.
Source: own work
Digging a little deeper into the data for this earnings cycle, five of the six sub-industries are expected to post positive growth in either revenue or EPS. One sector, the Equipment and Supplies industry, is projected to see revenue decline while another, the Pharmaceuticals, is projected to see EPS decline. The best-positioned industry within the healthcare sector is the Services and Providers. This industry is expected to produce 15% EPS growth this quarter.
Service providers like Patterson Companies Inc. (PDCO), National Healthcare Corporation (NHC), Meridian Bioscience (VIVO), and United-Guardian (UG) all pay market-beating distributions.
The Real Estate sector is another top pick in terms of earnings growth. It too is expected to see earnings growth acceleration double from this year to next. The caveat is that growth is about half that of the Healthcare sector and lags the group. The upshot is that the Real Estate SPDR XLRE pays a much higher dividend than Healthcare, about 3.35%, and investors can get double exposure by targeting health services and providers with REITs. The SABRA Healthcare REIT (SBRA) pays 9.0% at today's prices, the Omega Healthcare Investors about 7.0%.
Other ETFs within the Real Estate universe include the iShares U.S Real Estate ETF (IYR) and the Vanguard Real Estate ETF (VNQ). Both yield more than 4.0% at today's share prices and invest in a diversified real estate strategy.
The Utilities Sector is my third pick in terms of earnings growth and earnings growth outlook but is by far the best in terms of dividends. The Utilities Sector ETF XLU doesn't yield quite as much as XLRE at this time but the history of growth and dividend safety you can find within the respective sector surpasses all others. A screen for market-beating yield among this group will return a long list of small, U.S. utility providers with decades of increase history and relatively safe payments. The average payout ratio for this group is 67%, slightly on the high-side of my comfortable range but still quite safe. The lowest of the bunch is 44% and several fall into the range of 50% to 65%.
Source: own work
The drawback is the growth rate. The average 5-year distribution growth rate for the group is only 5.42%. Even the broad market S&P can beat that. The offsetting factor is that yield is more than double in some cases and nearly double in all the rest. You may not get the year-to-year increases you will with other sectors but the payouts will be larger to start and get bigger from there.
Earnings growth is going to be spotty for the next few quarters at least. The trade war, geopolitics, and slowing global economic activity are the culprits. That said, there is still growth to be found in this no and low-growth environment. The sectors best poised to deliver that growth, and sustainably, are the Real Estate, Utilities, and Healthcare sectors. Along with low to no exposure to foreign markets these sectors have real asset appeal and, oftentimes, market-beating dividends and positive outlook for dividend growth.
With explosive earnings growth becoming ever elusive in today's market I expect dividend growth stocks will outperform the broad market over the next few years.
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Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.