As volatility picks up and return expectations remain muted, the approach of investing in high quality companies is increasingly appealing to many investors. We believe that combining quality characteristics with dividend payers can result in a portfolio of companies with stronger financials, higher dividend yields, and lower valuations than the broad market. This can represent an attractive core element of an income-focused portfolio.

What is Quality?

While there are a handful of definitions for quality, S&P defines it as a combination of a company’s return on equity (profitability), debt to book value (financial leverage), and its change in net operating assets (accruals ratio). Companies that score well across these three metrics tend to make good use of invested capital, avoid taking on too much risk through borrowing, and generate strong cash flow. As such, these ‘high quality firms’ generally are on more stable footing than ‘low quality firms’, and therefore more resistant to external economic shocks. Research on quality also shows that these high quality firms tend to outperform low quality firms over the long run.

Source: Kenneth French Library. Quality in Kenneth French Library based on Operating Profitability. Highest quality quintile of companies compared against lowest quality quintile of companies by this measure against the S&P 500 since the end of 1993. Data through 12/31/18.

Past performance is no guarantee of future results.

Why Combine Quality with Dividend Yield?

While quality alone has historically been a positive factor for stock performance, we think it can be useful to pair a quality screen with one that also considers companies with higher dividend yields.

Dividend Stability: Given that quality metrics help illustrate a firm’s potential profitability and financial stability, they also are insightful into the likelihood of a firm maintaining its dividends – that is, higher quality firms are more likely than low quality firms to maintain or grow their dividend. This is an important attribute to income-oriented investors who prefer dividend stability over other characteristics, like high dividends or growing dividends.

Source: Bloomberg. Data as of 2/4/19. Data is based on % of index constituents, not weight.

Lower Volatility: As shown in the chart below, the quality nature of these dividend paying stocks measured by these criteria have also provided a buffer on some of the recent downside risk in the market.

Source: Bloomberg. Data represents rolling 90 day volatility since 7/13/18, the inception of the QDIV ETF. Data through 2/4/19.

Attractive Characteristics: While quality select stocks based on profitability, debt, and accruals, dividend screens bring in companies with higher dividend yields. This higher yield can either come from a higher payout ratio (i.e. a company pays out more of its earnings as dividends) or as a lower-priced security, demonstrating value characteristics. When dividend yield is combined with quality, investors can isolate companies that have both strong financials and lower valuations, both of which have historically shown to contribute positively to returns.

Source: Bloomberg. Data as of 2/4/19. *median values of constituents of indexes with data used

Conclusion

Quality dividend strategies may warrant further attention in today’s markets due to their strong fundamentals, lower valuations, and balance sheet strength. We believe taking a quality approach to the dividend space may potentially reduce certain risks relative to the broader market, and may provide a solution for investors concerned about dividend sustainability compared to other types of dividend strategies.

QDIV: The Global X S&P 500 Quality Dividend ETF invests in U.S. equity securities included in the S&P 500® Index that rank within the top 200 of the index’s universe by both quality score and dividend yield. For current performance of the fund please click on the fund’s name above.