Dividend stocks are a popular destination for investors in bear markets. The ideas behind using these investments to endure market downturns are simple. For starters, dividends provide current income, and that can provide a cushion in down market environments. Second, consistent dividend payers have proven to be less volatile and perform better in downbeat markets than their growth stock peers.
In a bear market, some sectors fall more than others. It is likely those sectors are either highly cyclical, such as consumer discretionary and materials, or littered with high-beta growth stocks, such as the technology sector. Broadly speaking, consumer discretionary and many technology stocks are not known as "dividend stocks." On the other hand, sectors with a reputation for being home to a fair number of steady dividend payers include consumer staples, health care, telecommunications and utilities. While there is no guarantee those sectors will rise in a bear market, their performance history has shown they are at least "less bad" in bear markets. The high dividends paid by many of the largest companies in these industries make their stocks sturdy in bear markets.
Look for Dividend Growth
Investors should not stop with merely finding stocks with alluring dividends to survive a bear market. A lot of companies pay dividends, but not all have extensive histories of raising payouts. Scores of U.S. companies have long histories of annual dividend increases. A good place to start your research is the S&P 500 Dividend Aristocrats Index. To be included in that index, companies must have track records of increasing dividends for at least 25 years.
Beware of Yield Traps
Many income investors chose stocks based on yield, but this is not always the best idea in a bear market. Put simply, a stock’s dividend yield is its share price divided by the annual dividend. For example, a $10 stock with a $1 annual dividend has a yield of 10 percent. What cannot be forgotten is that dividend yields rise when the share price falls. In a bear market, plenty of stocks fall because that is what the broader market is doing, not because their underlying fundamentals are bad. However, not all high-yield stocks are value propositions. Some of these stocks have been beaten up for a reason, and the reason probably is not good.
Traits of Strong Dividend Payers
Investors should do additional homework to find dividend stocks that hold up well in bear markets. One of the most important traits to look for is a company’s debt-to-equity ratio. If the company has a high debt-to-equity ratio, it could come under pressure from other investors to use available capital to reduce debt rather than pay dividends. On a related note, look for companies that are prodigious generators of free cash flow. Having excess cash flowing in, even in a bear market, can help companies pay down debt if they need to, invest in the business and reward shareholders.
Todd Shriber is a financial writer who started covering financial markets in 2000. He worked for three years with Bloomberg News and specializes in analysis of stocks, sectors and exchange-traded funds. Shriber has a Bachelor of Science in broadcast journalism from Texas Christian University.