The year 2020 was a watershed for dividend investing that many investors were not expecting: it clearly demonstrated that growth, consistent payout, and sustainability (GPS)[1] matter. Throughout the COVID-19 crisis, many companies have pushed back against the idea of paying (let alone initiating) dividends. Since the pandemic peak, consistent double-digit earnings growth, significant price appreciation, and operating leverage have seen cash flow grow at record levels. The lack of pressure from investors to consider dividends, particularly in sectors like technology, has thus far allowed these companies to avoid any increases or initiation.

Yet tech companies, and even blue-chip cyclicals, have moved past the pandemic cycle peak with better-than-ever cash flow growth—which is expected to continue in the years to come. With consistent and sustainable earnings, there is an increasingly real probability that excess cash will be regularly returned to investors in the form of dividend initiation, increased payouts, or even buybacks. From commodity to technology companies, balance sheets have swelled faster than businesses can make use of the capital, and all this is happening amid a rising demand for income.

The model: Using machine learning to predict dividend increases and cuts

The i³ Investments™ team at Guardian Capital LP has developed and tested an ensemble of machine learning models, using algorithms like random forest and XGBoost, that aim to predict which stocks are expected to see meaningful upward and downward dividend per share (DPS) growth on both an absolute and relative basis to the market over the next twelve months. We have also developed models that aim to predict the probability of a dividend cut, which is crucial for dividend income seekers. We rigorously tested a number of potential explanatory variables in both fundamental and alternative data and identified key drivers of dividend trends. Our models found important non-linear relationships between factors such as historical and predicted dividend yield, dividend growth, payout ratios, news sentiment, quality, and the entire spectrum of revenue and earnings per share (EPS) revision data. Our model’s predictions exhibited significant skew at the tails, meaning the actual results a year out were better than the predicted results at both the highest and lowest predictions for dividend growth.

The result: Actual results validated the model prediction during a real-world pandemic crisis

Example for illustrative purposes only

Throughout the pandemic, of the 1,934 dividend stocks we model, 331 either cut or suspended their dividends by greater than 50 percent of their past twelve-month payouts. During the peak of the pandemic cycle, our global combined universe of these 1,934 stocks had a prediction accuracy rate of over 81 percent.[2] The regional accuracy rates were 85 percent (US), 70 percent (Europe), 82 percent (Asia), and 89 percent (Canada).

If our artificial intelligence research and 2020 pandemic experience have taught us one thing, it is that chasing yield for yield’s sake is not the best way to capture income. Such an approach has historically proven to be fraught with value traps, unannounced dividend cuts (yield traps), and the mesmerizing of investors with high yield through underperformance.

As shown in the table below, during the pandemic peak, 34 percent of stocks that yield above 6 percent actually saw their payouts fall by over 50 percent through outright cuts or suspensions.

Forty-two percent of the stocks with a greater than 40 percent chance of a dividend cut actually cut their dividends.

Source: Guardian Capital’s proprietary GEMX(GPS) analytics model based on data from Thomson QAD, Factset Universe. Internal GEMX Universe. Stocks counted toward actual cut of suspension if DPS as of July 21, 2020, is less than half of the DPS as of March 15, 2020.

Source: Guardian’s proprietary GEMX(GPS) analytics model based on data from Thomson QAD, Factset Universe. Internal GEMX Universe. Stocks counted towards actual cut of suspension if DPS as of July 21, 2020 is less than half of the DPS as of March 15, 2020.

The forecasted opportunity

Based on our model’s forecast, high-dividend stocks yielding above 6 percent, adjusting for volatility, have seen significant drops in the probability of a dividend cut, from 50 percent to now lower than 20 percent. This allows for opportunistic buying of stocks that not only have high yields, but also have the potential to raise their dividends.

The charts below show four dividend quartiles, including the fourth quartile, which represents the top 25 percent of the highest-yielding stocks across various points in time. Since the November 2020 vaccine announcements, we have witnessed a dramatic drop in the probabilities of cuts across all regions in the world. However, it was the third quartile that demonstrated the optimal risk–return trade (or the best yield of a unit with a chance of a dividend cut).

It is also clear that the risk of dividend cuts rose and fell in a highly correlated fashion between regions, and that chasing yield, or the highest quartile (the fourth), was extremely risky—a risk that could rear its head again amid another crisis.

Source: i³ Investments, Guardian Capital’s proprietary GEMX(GPS) analytics model based on data from Refinitiv, Factset. Internal GEMX Universe. Forecasts were run daily from Jan. 1, 2020 to July 31, 2021.

The quartile of highest-yielding stocks (the fourth) is represented by real estate investment trusts, banks, and energy and commodity stocks that have, in the recent past, cut or suspended their dividends but are awash with cash or have replenished their balance sheets and are looking to increase payouts or share buybacks in a way that is friendly to shareholder yield.

Cast the net where the fish swim upstream

However, the biggest story, in our opinion, is the dividend prediction for markets as a whole after the pandemic peak. Globally, stocks that have had historically low payout ratios or that are yielding less than 2 percent are expected to see some of the biggest dividend increase announcements. We call these “dividend growers,” and we expect them to have a strong payout increase within the next 12- to 24-month cycle. Furthermore, it is not unthinkable to expect some of the stocks that are non-dividend payers to consider initiating a small dividend.

Stocks that pay dividends in the range of about 4 to 6 percent are showing some of the strongest secular dividend growth, regardless of the cycle or regimes that afflict markets. The highest-yielding asset class (>6 percent yield) has seen a dramatic recovery and stabilization, and our model predicts growth rates in the US and Europe to be higher than their pre-pandemic levels. We believe payout equities are having a moment again. For income-starved investors, that’s a positive. We have always stated that dividends are not the icing on the cake, but rather they are the cake. With dividends having contributed over 60 percent of MSCI World Index total returns since 1969, we feel it is always worth discussing their benefits.

Source: i³ Investments, Guardian Capital’s proprietary GEMX (GPS) analytics model based on data from Thomson QAD, Factset Universe. Internal GEMX Universe. Forecasts were run daily from Jan. 1, 2020 to July 21, 2020.

The chart above shows the timeline of dividend growth through the pandemic cycle to date and demonstrates that yield has normalized due to both price appreciation and a resumption of payouts. 

There are few quality opportunities for income generation. A company’s ability to reliably grow its dividends annually without a single cut over multiple years should be an indication of a certain level of financial strength and management discipline. Investor concern around market volatility may warrant a focus on dividend growers’ commitment to shareholder yield that includes consistent capital return via dividend increases, buybacks, and debt reduction. This may provide a more sustainable and stable source of income and a lower volatility means of getting cash back from companies. The recovery phase of the COVID-19 pandemic appears to be an opportunity to participate in a rare but broad cycle of dividend and buyback increases. The i³ Investments team believes payout equities are having a moment again.

[1] G – Dividend growth; P – Dividend payout; S – Sustainable cash flow growth and low probability of dividend cut.

[2] The dividend cut prediction was run on March 16, 2021. Dividend cuts were verified on July 31, 2021.

This communication is for informational purposes only and does not constitute investment, financial, legal, accounting, or tax advice or a recommendation regarding a security. The opinions expressed are as of the published date and are subject to change without notice. Assumptions, opinions, and estimates are provided for illustrative purposes only and are subject to significant limitations. The use of hypothetical, simulated results is accomplished through the application of a model with the benefit of hindsight and the calculations are subject to inherent limitations. This communication includes information concerning financial markets that was developed at a particular point in time and is subject to change at any time. This may also include forward-looking statements concerning anticipated results, circumstances, and expectations regarding future events, which require assumptions to be made and are subject to inherent risks and uncertainties. There is significant risk that predictions and other forward-looking statements will not prove to be accurate. Equity markets are volatile and will increase and decrease in response to economic, political, regulatory, and other developments. Dividend changes represent past activity, and there is no guarantee that dividends will continue to be paid in the future.