Investors today are facing a very challenging economic climate.
Interest rates in Australia are at their highest level in 12 years. Significant inflation has brought greater costs to companies' balance sheets. Consumer retail spending is slowing, as is economic growth.
What's an investor to do?
Top United States-based broker Morgan Stanley provides some insights on the best plan of attack.
Go for dividend stocks over growth stocks
Morgan Stanley says dividend stocks are more likely to form the bulk of returns for investors today. The broker is not alone in its view here.
Morgan Stanley says:
The next several years are likely to be marked by lower equity returns and higher volatility, which could lead dividends to account for a greater portion of total stock market return.
From 2013 through 2022, about 17% of the S&P 500 Index's total return came from dividends. But over a longer horizon, starting from the 1930s, dividends accounted for 37%.
The next several years will likely look more like the longer-term picture.
Companies that pay reliable dividends — and even increase them — have financial strength and discipline.
The broker points out that in 2022, the S&P 500 Index (SP: .INX) lost about 18%. However, the S&P 500 Value Index (a proxy for dividend stocks) lost about 5%, and the S&P 500 High Dividend Index lost about 1%.
What type of dividend stocks?
To start with, Morgan Stanley suggests defensive shares.
Defensive shares are those with stable earnings in any economic conditions, like supermarkets.
Among those defensive shares, Morgan Stanley recommends looking for businesses with strong management, a high dividend payout ratio, and strong free cash flow.
And if the company has a track record of maintaining and even increasing its dividends throughout economic cycles, that's even better.
Which defensive shares offer the best dividends?
Certain market sectors offer greater stability and reliability. Morgan Stanley likes industrials, healthcare, and consumer staples stocks.
In relation to industrials shares, the broker said:
In particular, we favor [US] defense companies that are likely to benefit from strong cash flows and bipartisan policy support: Mounting geopolitical conflict and aging defense infrastructure spurred Congress to boost defense spending by 10% for 2023, up from an average 3% per year since the 1940s.
We expect lawmakers to continue to support increases to the defense budget and believe companies with exposure to high-priority programs, such as aeronautics and space, stand to benefit.
In relation to healthcare, the broker points out that US healthcare stocks have outperformed the market by an average of 13% over the past four recessions.
It adds:
… exposure to innovative trends like genomics and medical AI may make the sector attractive to investors seeking to play both offense and defense.
Consumer staples companies that are able to raise prices without hurting sales and are increasing their marketing budgets to drive revenue are the ones to go for.
The broker adds:
As consumer companies recover from elevated commodities prices, expect to see improved profit margins for select companies.
Consider stocks with attractive valuations and a history of healthy dividend payments.
Examples of defensive ASX dividend stocks
To recap, Morgan Stanley says the four things to look for when researching ASX dividend stocks are:
- Defensive companies in the industrials, healthcare, and consumer staples sectors
- Strong management team
- High dividend payout ratio
- Strong free cash flow.
To get you started, here are some of the biggest companies in each sector that pay dividends.
In the healthcare arena, the biggest ASX dividend stock by market capitalisation is CSL Limited (ASX: CSL).
Other ASX healthcare stocks that pay dividends include Sonic Healthcare Ltd (ASX: SHL) and Cochlear Limited (ASX: COH).
Among industrials shares, the biggest ASX stocks paying dividends by market cap include Transurban Group (ASX: TCL), Brambles Limited (ASX: BXB), and Reece Ltd (ASX: REH).
The biggest ASX dividend stocks in the consumer staples sector include Coles Group Ltd (ASX: COL), Woolworths Group Ltd (ASX: WOW), Endeavour Group Ltd (ASX: EDV), and Metcash Limited (ASX: MTS).
These are just examples. You'll need to dig into the books of each company to determine if they have the management strength, payout ratios, and cash flow levels to justify your investment.
One warning for investors…
Look out for dividend traps!
These are the ASX dividend stocks trading on elevated trailing yields due to a fallen share price.
They can be a big buying mistake if the shares are falling due to business problems or reduced earnings forecasts.
