Unlocking the Power of Dividend Stocks
As we navigate the complex landscape of the stock market, one thing is clear: dividend stocks are becoming increasingly attractive. With many market participants focused on more expensive Technology holdings and the excitement surrounding artificial intelligence, we believe that high-quality dividend stocks are being undervalued.
A Rotation Away from Dividend Stocks
Since the end of 2022, there has been a significant rotation away from dividend stocks and into Technology stocks. This shift has created an attractive opportunity to own high-quality above-average dividend stocks at below-average valuations. Our view is that many dividend stocks continue to trade at historically cheap valuations compared to the broad market.
Measuring Valuation: Relative Yield
Our preferred valuation metric for dividend stocks is relative yield, which we define as a stock or portfolio dividend yield divided by the S&P 500 dividend yield. A high relative yield compared to its history indicates a low valuation for the stock or portfolio, while a low relative yield ratio indicates a high valuation, all else equal. At the end of the third quarter, the relative yield of the Madison Dividend Income Fund was 2.1x the S&P 500, which was near the high end of its historical range since inception and 20% higher than the relative yield of the Fund at the end of 2022.
The Madison Dividend Income Fund
The Madison Dividend Income Fund goal is to achieve long-term outperformance over a full market cycle while taking below-average risk. To pursue this objective, we employ a relative yield strategy where we buy stocks that have a dividend yield at least 1.1x the S&P 500. We then analyze a company’s business model, balance sheet, and cash flow profile to assess its ability to continue paying dividends.
A Relative Yield Example: Honeywell
One attractive relative yield candidate is Honeywell (HON), a premier industrial conglomerate with leading businesses in commercial aerospace, industrial automation, energy sustainability solutions, and building automation. HON has a sustainable competitive advantage due to its wide installed base of equipment, strong reputation, pricing power, high customer switching costs, and technological expertise. Our thesis on HON is that it appears well positioned for consistent growth, driven by a recovery in commercial aerospace following the Covid pandemic coupled with favorable secular trends in automation, remote security management, and energy savings in buildings.
The Fund’s Performance
For the third quarter, the Madison Dividend Income Fund (Class Y) returned +10.1%, which outperformed the S&P 500, Russell 1000 Value, and Lipper Equity Income peer group returns of +5.9%, +9.4%, and +8.2%, respectively. On a year-to-date basis, the Fund returned +9.5%, which compared to the S&P 500, Russell 1000 Value, and Lipper Equity Income peer group returns of +22.1%, +16.7%, and +16.2%, respectively.
A Generational Opportunity
We believe that owning high-quality stocks with above-average dividend yields is the best way to provide income and generate attractive long-term returns over a full market cycle while limiting drawdowns in bear markets and market corrections. With valuations now reaching historically cheap levels compared to the broad market, we see a generational opportunity to own a high-quality portfolio of dividend stocks with attractive characteristics.
Sincerely,
John Brown, CFA & Drew Justman, CFA
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