How Your Dividend Portfolio Can Survive Disruptive Tech

Summary

• Income investing is a popular and time-tested approach to generating wealth over the long term.
• However, many popular income investments are now at risk due to the rise of disruptive innovation.
• What income investors should do.
• Looking for more investing ideas like this one? Get them exclusively at High Yield Investor. Learn More »

Photo by wenjin chen/DigitalVision Vectors via Getty Images

Dividend investing is a popular and time-tested approach to generating wealth over the long term.

In fact, dividend paying - and especially dividend growing - stocks, have a track record of absolutely crushing the stock market (SPY) (DIA) (QQQ):

source

This is even more remarkable when you consider that many of the greatest individual stock performers such as Amazon (AMZN), Berkshire Hathaway (BRK.A) (BRK.B), Netflix (NFLX), Google (GOOG), Facebook (FB), and Tesla (TSLA) have never paid a dividend.

However, many popular income investments are now at risk due to the rise of disruptive innovation threatening their business models.

Just looking at the recent gap in performance between dividend-oriented funds (SPYD) and tech-oriented funds says it all:

Data by YCharts

Not only that, but there is a strong case to be made - championed by Ark Invest's disruptive innovation ETFs (ARKK) (ARKQ) (ARKG) (ARKX) - that this performance gap will continue into perpetuity because, given that innovation is increasingly crucial to surviving and thriving as we move into a world of tech and data dominated winner-take-most industries, the companies that "waste" cash on dividends and buybacks will fall behind, while those companies that reinvest aggressively in developing their technological and data capabilities will surge ahead.

We see this on display everywhere:

In retail, companies like Kohl's (KSS), Macy's (M), and even their landlords like Federal Realty (FRT), Simon Property Group (SPG) and Macerich (MAC) have made dividends a key component of their capital allocation strategies for years. Meanwhile, their technological capabilities remained relatively stagnant.

In contrast, Amazon and even the likes of Walmart (WMT) and Costco (COST) have either entirely foregone dividends and buybacks or simply kept them at a low level in order to conserve plenty of cash for innovating and surging ahead by investing in their e-commerce and supply chain capabilities.

The banking sector is faced with a similar conundrum: PayPal (PYPL) and Square (SQ) do not pay dividends, but are racing ahead by investing aggressively in disruptive FinTech that enable people to increasingly utilize mobile banking apps, while traditional big banks like Wells Fargo, JPMorgan Chase (JPM), and Bank of America (BAC) are innovating at a much slower pace while forking over meaningful sums of cash to shareholders via buybacks and dividends.

It is also happening in the office vs. work-from-home space (Boston Properties (BXP) pays a big dividend vs. Zoom Technologies (ZM) which does not in order to invest heavily in technology development and growth), the automotive space (General Motors (GM) and Ford (F) used to pay fat dividends compared to Tesla (TSLA) which has never paid a dividend and instead invested aggressively in developing battery and autonomous technology), and even tech (IBM (IBM) is a committed share repurchaser and dividend payer to the point of becoming a borderline high-yield stock against the likes of AMZN, GOOG, Oracle (ORCL), and Microsoft (MSFT) which have all outperformed due to investing aggressively in advancing their cloud technologies).

We could go on, but hopefully you get the idea: in case after case, non-dividend paying disruptive tech has been crushing dividend-paying traditional businesses.

Of course, this isn't the full story: many of these disruptive tech businesses with runaway valuations are still not profitable and lack clear guidance on achieving profitability (for example Palantir (PLTR), Uber (UBER), and Invitae (NVTA)), despite having been around for a decade or longer.

While extremely low interest rates (GOVT) make this somewhat palatable, at some point they will need to deliver profits for shareholders.

Data by YCharts

In the meantime, their extreme sensitivity to interest rates and shaky financial footing make them uncomfortable positions for retirees and other conservative investors.

What are dividend investors to do?

#1 - Maintain Balance

First and foremost, it is important to avoid the temptation to panic or overreact with your asset allocation strategy. Just because one sector's performance has been crushing another's in recent years, does not mean it will last forever, as we have seen happen repeatedly in the past.

Even if disruptive tech continues to grab market share from traditional businesses into perpetuity, it does not necessarily mean that it will outperform in terms of stock market performance. After all, tech valuations - for the most part - remain sky-high relative to dividend paying value stocks.

For this reason alone, it is generally best to take the guesswork and emotion out of the equation and deploy a somewhat balanced allocation across all sectors and business types and then rebalance regularly to take advantage of excessive market shifts towards each business model.

We apply this approach at High Yield Investor by diversifying across a broad range of sectors, though we still do overweight sectors that we find most opportunistically valued at the moment, like Midstream and Utilities:

source: High Yield Investor Portfolio Sheet

At the same time, however, we still acknowledge that the argument for continued long-term outperformance from disruptive technologies has a lot of strong points behind it, so we still maintain some exposure to the tech sector along with a sizable investment in renewable infrastructure to hedge our investments in midstream.

Additionally, this approach gives us a good balance between cash flow today from high yielding traditional business models like midstream MLPs, insurance companies, real estate, and utilities - the income that dividend investors love (and in many cases, need) so much - and long-term growth and disruption resistance from businesses in tech, healthcare, and renewable infrastructure to keep our portfolio relevant and prosperous well into the future.

#2 - Be Selective

Additionally, remind yourself once again of the components that have made dividend investing historically so great:

• Dividend Growth Investing

Dividend growth stocks are a great hybrid of both investing approaches that have proven to outperform all others. This is because they benefit from the accountability, shareholder and free cash flow generation focus, and investing efficiency that regular dividends demand from management teams while still retaining enough cash and/or possessing dynamic enough business models to be able to grow and keep up with technological change.

• High Returns on Invested Capital

Often operating hand-in-glove with dividend growth stocks for the aforementioned reasons, but nonetheless important to monitor independently is the return on capital being generated by the business. If the company can sustain high returns on invested capital, then it means that you can rest assured that management is not retaining too much capital while still retaining enough to remain highly competitive. These are dividend stocks that you can invest in relatively guilt and worry free.

• Healthy Balance Sheets

Last, but not least, insisting on balance sheet health is crucial for dividend investors, since companies that leverage up in order to maintain competitive have no business returning cash to shareholders via dividends or buybacks, because it really isn't extra cash at all. Essentially, the company is borrowing money and then giving it to you.

Companies that do this are sowing the seeds of their own destruction by placing a weight around their own necks in the form of reduced liquidity, increased costs, and ultimately misguided shareholder expectations and eventually put themselves in a position where they will either have to crush income investors' hopes and dreams with a sudden and dramatic dividend cut (i.e., Kinder Morgan (KMI) or General Electric (GE) style), or eventually fall behind and face significant business and financial distress.

Some great examples of combinations of this magical trio of factors come up in the retail sector: Lowe's (LOW), Home Depot (HD), and Tractor Supply (TSCO) are three bricks-and-mortar retailers that have proven to be dynamic dividend growers and share repurchasers who also managed to retain plenty of cash flow to develop strong moats in their niches and build the technological and logistical capabilities to survive and thrive in the age of e-commerce.

As a result, they have totally crushed the market over time, despite AMZN and WMT trying to compete with them to some degree:

Data by YCharts

Another great dividend growth stock that we have identified and hold in our portfolio is ATCO (OTCPK:ACLLF). As we detail in Our Top Buy For March, ACLLF not only has an impressive dividend growth track record:

source

but it also generates sector-leading returns on equity due to numerous competitive advantages, and has a rock-solid A-rated balance sheet.

#3 - Insist On Value

Additionally, it is essential to not lose perspective on the price being paid for businesses. Just because a stock has a fat dividend yield or a great reputation for being a dividend growth stock does not mean it is on sale or worth investing in. Doing this will not only lock in higher income for you, but it will also make your investments more conservative by reducing your downside potential.

An example of why this is so important can be found in AT&T (T). In our recent post The Chickens Are Coming Home To Roost At AT&T, we pointed out that, while the stock is trading at a historically attractive dividend yield and price per share, its EV/EBITDA ratio is actually historically high due to the company taking on heavy debt in recent years that it used to grossly overpay for declining businesses. As a result, shareholder equity has been eroded by massive impairments on these acquisitions, though the cashflow per share has been sustained by ever-increasing sums of cheap leverage. However, the truth is starting to come out as the company was recently forced to freeze the dividend and halt its decades-long dividend growth streak.

#4 - Look For Disruption-Proof Industries

While focusing on the qualities in section 2 will often lead you here, it still bears mentioning that it is worth looking for disruption-proof sectors for high quality dividend payers. Though they can be hard to find in the current low-yield environment, they do exist and often prove to be very reliable dividend growth stocks given their increased safety and tendency to possess lengthy growth runways.

We find the best disruption-proof sectors right now for finding quality dividend paying stocks are the renewable energy space as well as the industrial real estate.

Investor Takeaway

Disruptive innovation is on the rise and interest rates remain at historical lows, making it arguably the toughest time in history to be a dividend investor. More and more companies are being forced to forego returning capital to shareholders in order to reinvest in their technological capabilities in an attempt to keep up in their rapidly-changing industries.

Meanwhile, the companies that are able to distribute extra cash to shareholders without fear of disruption are getting bid up to prices where the total return potential and/or income yield are unattractive in most cases.

Does that mean that investors should abandon dividend investing and dive in headfirst into either growth or bonds? Not necessarily. We believe that investing in bonds at current interest rates is not the path an intelligent investor should take and also realize that, for some investors, going all-in on Cathie Woods' latest ETF or even the FANG stocks is not prudent either given their need to finance their lifestyle and/or avoid excessive market sentiment risk.

The path forward then is to be increasingly cautious in what dividend stocks you pick and to insist on traits that indicate sustainability to the business model, the balance sheet, and the income stream instead of just chasing the highest yields and the deepest value opportunities.

Analyst’s Disclosure: I am/we are long ACLLF, PLTR. 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.

Comments

[jasonjones]

Dividends wasteful? Are employee salaries wasteful? CEO salaries wasteful? If I "own" a company then I want PAID to own it. Stockholders anymore are just considered suckers.

[Samuel Smith]

@jasonjones when innovation is needed to remain competitive, bleeding cash from the balance sheet to pay dividends is considered wasteful.

[HardytheTrader]

The best dividend growers are almost all tech stocks from the semiconductor industry. Its crucial to be in tech nowadays

[Samuel Smith]

@HardytheTrader thanks for sharing

[bryan555]

One interesting way to play this is closed end funds such as BSTZ and BMEZ, which invest in cutting edge technology, but pay substantial dividends. Could include AIO and STK in that category, too.

[Samuel Smith]

@bryan555 interesting.

[villanema]

@bryan555 STK is en exceptional asset. However it’s great increase in the last year

[GDPPP]

A dividend portfolio can survive disruptive tech only through:

1) Innovation, which means adapting to changing consumer and business trends
2) Reinvesting a portion of those profits/cash flows into R&D and bolt on acquisitions that increases or keeps ROIC above market averages for a long time and
3) Finally getting rid of low margin business segments (before they turn to commodity products and are subject to pricing pressures).
4) Use effective distribution channels and see if it makes sense to go DTC

[Samuel Smith]

@GDPPP thanks for sharing!

[pascout]

I think that there is space for both traditionnal and « disruptive » businesses. Several of these new companies are providing business services. They help consumer businesses deliver their services and goods at better cost and quality. But when I look at my top expenses and people around me, the highest amounts go to shelter (mortgage, utilities, maintenance), food, cars with fuel and maintenance, medicals (drugs, healtcare), etc. These goods and services are still mainly provided by traditional businesses and there is new competition for sure. But, the new businesses won’t be wiping the profits of the traditionnal ones for a good time, at least most of them. It makes no sense for Google, Microsoft, Servicenow, or Zoom that GM, Shell, Walmart and CVS die. They are their customers. Their purpose is to help them become better. Of course there are changes. And these companies make enough profits to return some to shareholders and evolve. It depends more on management culture and vision than external forces. At least to a point. So I think that people thinking that the « new » economy will be wiping the « old » one soon have it wrong. But, management is better not be sleeping at the wheel for sure.

[Samuel Smith]

@pascout thanks for sharing those good points. To be clear, I agree that there are companies that have business models that allow them to innovate and return capital to shareholders. The real issue lies with those businesses that leverage up in order to try to do both.

[manfac]

I think your article can be summarized by seeing the Forrest and Not the Trees.
Someday the forrest maybe gone due to over harvesting the tree.

To prevent that unfortunate occurrence you must establish an "arbor like "
culture ; one of the present and of course the future.

A Dividend Investor has an " arbor like" mentality that only can see today and tomorrow will be his new found forrest of dividend harvest.

[Samuel Smith]

@manfac interesting analogy. Thanks for sharing.

[dynx]

Stick with value for the long run. There are some disruptive players that become obvious after like Amazon that are worth investing in but most “disruptive” tech is code for “we don’t make money but we’re killing an industry by surviving on investor money while selling sh*t at a loss”. Those things won’t last but are nice momentum plays if you’re comfortable in that area. Reward may be high but so is risk.
There are few income ideas that make sense right now. QCOM, ABBV....and I hate to say it but you mentioned it....I’m tempted by KMI.

[Samuel Smith]

@dynx thanks for sharing your view!

[User 21925891]

I am mostly in value oriented dividend growth stocks, but have taken advantage of the recent downturn in disruptive growth through the ARK ETFs. There's room in the portfolio for both.

[Samuel Smith]

@User 21925891 agreed.

[PlumberMD]

Nice article. I’m concentrated heavily in Value currently. Energy and Tobacco. I read earlier today that Hwang from Archegos is very close to Wood from Arkk. I’m very concerned ARKK and Wood are using same risky leverage techniques as Hwang did. If ARKK implodes, that will set off a major Tech correction that’ll dwarf the Dot Com Bubble sell off. Any thoughts on this?

[Samuel Smith]

@PlumberMD I am not aware of any leverage use from ARK.

[Retire2020]

@Samuel Smith Thanks for the timely reminder for income investors like me. Interestingly you use ROIC as a factor instead of ROE. Are there any particular advantages of using ROIC? Appreciate your thoughts. Thanks and all the best.

[Samuel Smith]

@Retire2020 both are useful and it really depends on the business model being assessed. ROIC in general is better because it removes the impacts of leverage and simply measures the profitability of the capital being deployed.