The market is dramatically underestimating the extent to which U.S. dividends can rise over the long term, opening up an opportunity for investors to cheaply build exposure to dividend yield growth, Goldman Sachs analysts said in a report.
Over the course of the recent global sell-off, dividend growth expectations, like stock prices themselves, plummeted.
But while stocks have practically erased those losses in the past two months, the outlook by investors for dividends does not seem to have improved much.
Since the market bottomed out in February, the S&P 500 stock index has surged by almost 16 per cent from intraday lows to sit just a 2-per-cent move away from setting a new all-time high.
The market's expected average annual growth rate on dividends among those same companies over the next 10 years, meanwhile, declined to practically zero in February from 5.9 per cent at the start of 2014. It has since rallied only modestly to 0.8 per cent a year.
"Within U.S. equities, the recovery in growth expectations should support the outperformance of our newly rebalanced dividend growth basket," said a group led by David Kostin, head of the equity team at Goldman Sachs. "It provides an attractive vehicle for those seeking a balance of yield and growth."
The pace of growth of U.S. dividends has been declining now for four straight quarters.
S&P 500 dividends rose by 4.6 per cent year-over-year in the first quarter to $11.04 a share. But the declining growth rate "has prompted clients to ask about the risks to S&P 500 dividends and the prospects for dividend growth going forward," the authors said.
The dividend swap market is pricing in 4-per-cent annual dividend growth in 2016. But over the next decade, that expected rate falls to just 0.8 per cent annualized. "This would mark the slowest 10-year pace since the 1940s and falls far below our 4-per-cent compound annual growth rate forecast through 2025," Mr. Kostin wrote.
The recent pressures on dividends have been most acute in the energy sector, unsurprisingly. Aggregate dividends paid by energy companies in the S&P 500 fell by 11 per cent last quarter, Goldman Sachs said.
"In some parts of the equity market, however, dividend growth remains strong." Financial dividends rose by 14 per cent in the first quarter, for example. The health-care sector increased dividends by 23 per cent.
"The extraordinarily low market expectations for dividend growth are also reflected in equity performance and valuations," the report said. The firm's dividend growth basket, which screens stocks for above-average dividend yield, reasonable payout ratio, and strong potential yield growth, trades at a 16-per-cent discount to the broader index.
The accompanying table contains stocks added by the firm in rebalancing its 50-stock portfolio.