Equities have jumped some major hurdles and broke new highs, but the markets are running out of steam after a multi-year bull rally and still face some challenges ahead. Consequently, investors should consider high-quality stock exposure, such as exchange traded funds that track dividend growers, as a way to limit risks while participating in any upside potential.
In recent weeks, U.S. stocks have pushed higher on a better-than-expected second quarter earnings season. U.S. valuations, though, are beginning to look pricey, so any further gains in equities will have to be supported by earnings growth.
“We believe further gains require a meaningful improvement in corporate earnings, particularly in developed markets,” BlackRock analysts, led by Richard Turnill, said in a research note.
“Stocks can still climb, provided EPS continues to recover and inflation remains subdued,” Sam Stovall, Managing Director and U.S. Equity Strategist at S&P Global Market Intelligence, said on a recent webcast.
SEE MORE: Quality Dividend ETF Strategies For Challenging Times Ahead
The stock market still faces a number of headwinds that could cause another risk-off event and trigger another major sell-off.
“High U.S. valuations and strong flows into U.S. equities already appear to reflect part of the good news. A U.S. market overweight has become a consensus trade, our analysis shows, raising the risk of sudden reversals,” according to BlackRock.
For instance, Stovall pointed to a so-called Wall of Worry that could shake investment sentiment, including an aging bull market, an earnings recession, a Federal Reserve rate hike, volatility in the equities market, depressed oil prices, lone-wolf terror attacks, an upcoming U.S. presidential election and a post-Brexit environment.
Consequently, during periods of heightened uncertainty but continued slow growth, investors may seek out more sturdy or stable companies.
“Investors tend to favor stocks with above-average consistencies of raising EPS and dividends during challenging times,” Stovall said.
[related_stories]Investors may also consider consistent dividend growers as a way to gain exposure to this group of quality companies as dividend growers and high quality stocks share a number of similar characteristics.
SEE MORE: Dividend Growth ETFs Could Continue to Outperform
“We prefer quality companies that can increase earnings in a low-growth
environment or grow their dividends,” BlackRock analysts said. “U.S. stocks with high dividend payouts, by contrast, look expensive and offer limited earnings potential at this time, we believe.”
ETF investors can also target U.S. dividend growers through a number of options. For instance, the iShares Core Dividend Growth ETF (NYSEArca: DGRO) specifically targets companies that pay a qualified dividend, must have at least five years of uninterrupted annual dividend growth and their earnings payout ratio must be less than 75%. DGRO shows a 2.28% 12-month yield.
The Vanguard Dividend Appreciation ETF (NYSEArca: VIG), the largest dividend-related ETF on the market, tracks U.S. stocks that have increased dividends on a regular basis for at least 10 consecutive years and has a 2.16% 12-month yield.
The Schwab US Dividend Equity ETF (NYSEArca: SCHD) includes 100 stocks based on strong fundamentals, such as cash flow to debt, return on equity, dividend yield and consistent dividend payouts for at least 10 consecutive years, and it has a 2.78% 12-month yield. The options is also the least expensive dividend ETF, with a 0.07% expense ratio.
The PowerShares Dividend Achievers Portfolio (NYSEArca: PFM) also selects companies that have increased annual dividends for 10 or more consecutive fiscal years. The ETF comes with a 2.22% 12-month yield.
The SPDR S&P Dividend ETF (NYSEArca: SDY) holds firms that have a minimum dividend increase streak of 20 years for inclusion and shows a 2.39% 12-month yield. Moreover, SDY follows a yield-weighting methodology that allocates a larger weight toward those with higher yields, so the portfolio leans toward more mid-sized companies.
The ProShares S&P 500 Aristocrats ETF (NYSEArca: NOBL) only targets S&P 500 companies that have increased their dividends for at least 25 consecutive years and offers a 1.78% 12-month yield.
Companies that have consistently increased dividends tend to be high in quality and show a strong potential for growth. These dividend growers have been able to withstand periods of market duress, exhibiting smaller drawdowns as investors sold off riskier assets, while still delivering strong returns on the upside, to generate improved risk-adjusted returns over the long haul.
Full disclosure: Tom Lydon’s clients own shares of NOBL, SDY.