Published on September 20, 2022

Generating investment income is challenging, especially in the low-yield environment we have been living with for the past decade. We believe that combining dividend growth stocks with an allocation to shorter-duration non-investment grade bonds is an effective solution.

Generating investment income is an age-old challenge that has been particularly difficult recently, as bond yields have been stubbornly low since the Great Financial Crisis. Creating consistent cashflow is a top priority not only for retirees, but also for endowments, foundations, and family offices that need to fund their operations. For many investors (and their advisors), the standard playbook is to increase their fixed income allocation and reduce their equity allocation, creating a reliable cashflow stream and decreasing portfolio volatility.

The downside of this approach is that it makes it harder for portfolios to grow, as investors are spending (rather than reinvesting) the proceeds from their fixed income investments. At the same time, they are dipping into their equity portfolio to cover any shortfalls or unexpected expenses. The combination can result in a portfolio with both declining principal and income potential.

In managing assets for both high-net-worth individuals and institutions for nearly 40 years, we have found that a dividend growth strategy, which invests in the subset of dividend-paying stocks with growing earnings and dividends, combined with an allocation to shorter-term non-investment grade bonds is a compelling solution to this problem. It provides a combination of relatively high current income, future income growth, and capital appreciation, while still limiting volatility.

Dividend-Paying Stocks Are Diverse

Despite its reputation as a haven for antiquated, stodgy companies, the dividend-paying universe is fairly diverse, with over 75% of the S&P 500 paying dividends. Although many dividend-paying stocks fit the traditional stereotype – mature businesses with above-average yields and slow growth rates – there are also plenty of dividend growth stocks – dynamic companies that operate in expanding markets with favorable long-term growth prospects.

We feel that investors with a multi-year time horizon are far better off holding dividend growth stocks than slower growing stocks with a higher dividend payout. In the short run, dividend growth stocks may produce slightly less income, as they generally offer lower payout rates, but over time their faster top-line growth should provide investors with compound returns in both their income stream and their share price appreciation.

Dividend-Paying Stocks Perform Better in Down Markets

Another benefit of dividend-paying stocks is that they tend to perform better in difficult markets than stocks that do not pay a dividend. This makes sense because investors gravitate toward profitable companies when sentiment turns bearish, especially those that return a portion of their free cashflow directly to shareholders.

According to a recent research note from Credit Suisse, this is exactly what has happened since the onset of the pandemic:

  “Companies that are returning more of their excess capital to shareholders in the form of   dividends are continuing to see incredibly strong performance. This is in contrast to buybacks,   which are often viewed by market participants as a driver of share prices.”

Dividend growth companies fared particularly well during the latest market selloff. In the past year, the S&P 500 Dividend Aristocrats Index has lost only -3.68%, compared to a much more substantial -10.62% loss for the broader S&P 500.

This feature is especially relevant today, given the current market volatility and the ongoing uncertainty in the economy. Of course, dividend-paying stocks can still decline in bear markets, and in extreme cases they can even skip a scheduled dividend payment, but their higher degree of profitability can provide protection in turbulent times.

Shorter-Term High Yield Bonds Are an Effective Complement

In our view, shorter-term high yield bonds pair particularly well with dividend growth stocks as part of an income generating strategy. They have two primary benefits. First, they dampen overall portfolio volatility. A pure dividend growth equity strategy might have more upside, but it also has substantially more downside. Layering in a fixed income buffer can help reduce drawdowns.

The second benefit is that they generally offer larger yields than dividend stocks, thus increasing current income. We particularly like shorter duration high yield bonds, as their coupons are higher than their investment grade counterparts. Their higher yields also translate into less interest rate risk than investment grade bonds of comparable maturity. (Interest rate risk, also known as duration, decreases as maturities fall and yields rise.) Likewise, they have less credit risk than similarly rated longer maturity issues, as the bondholder is exposed to the borrower for a shorter period of time.

Our Philosophy in Practice

Our views about generating investment income have been shaped by decades of helping both individuals and institutions reach their long-term financial goals. In our experience, the best outcomes occur when investors are able to position their portfolios to generate growing income streams without sacrificing capital appreciation or taking on too much risk. To help our clients achieve this, we have developed the Growth & Income Fund, which utilizes a flexible combination of our favorite dividend growth stocks with a selection of shorter-term non-investment grade bonds.

Stocks: Industry Leaders and Secular Growers

We believe the best way to deliver strong long-term performance is to build an equity portfolio of attractively valued stocks issued by leading or dominant companies in their respective industries. These firms are generally able to gain market share over time and enjoy higher margins. This enables them to grow revenues and free cash flow, which allows them to raise dividends faster than their competitors. Additionally, they are typically more durable and hence can be owned for many years, improving the tax efficiency of our strategy.

We also look for companies that benefit from secular tailwinds – firms that are selling products and services in sectors of the economy that are undergoing structural growth. Currently we are focusing on several areas, including the shift away from carbon-based fuels to alternative energy, the shift toward electric vehicles, the shift from brick-and-mortar retail to e-commerce, and the digitization of the economy, to name a few. We believe these sectors should grow over the long term, regardless of the business cycle, and the individual companies should be able to grow faster than the overall market.

Bonds: A Steady Source of Income

We supplement the income from our equities with a carefully selected portfolio of mostly shorter-duration high yield bonds. We emulate the philosophy of our Strategic Income fund within our fixed income allocation, which means we are always looking for the areas of the market that have the most attractive risk/reward characteristics, regardless of credit rating, sector, or maturity. At the same time, we are careful not to stretch for yield, which reduces our losses in weak markets.

As you can see from the scatterplot below, we have been successful with this approach. The x-axis plots the downside capture ratio , which measures how an investment performs during falling markets. A lower number is better, as it indicates the portfolio is less correlated with changes in the market. The y-axis plots the upside capture ratio , which of course is the opposite, and a higher number is better.

Upside Downside Capture Scatter Graph
Source: eVestment

 

 

Since inception, the downside capture of the fixed income portion of the Growth & Income Fund is decidedly lower than both the high yield index and every high yield bond fund in the Lipper universe. At the same time, the upside capture is near the top of the peer group and almost identical to the high yield index.

Final Thoughts

Although no single portfolio is appropriate for everyone, we believe that most income-seeking investors would benefit from maintaining at least some exposure to dividend growth stocks and shorter-term high yield bonds. At Osterweis, we offer the Growth & Income Fund, which seeks to provide a combination of current income, future income growth, and capital appreciation.

 

 

1The Dividend Aristocrat Index is a subset of the S&P 500 that is made up of companies that have increased their dividend every year for at least 25 consecutive years.

2The downside market capture ratio is calculated by dividing the portfolio’s return when the benchmark (Bloomberg U.S. Aggregate) performance is negative by the return of the benchmark during the same periods.

3The upside market capture ratio is calculated by dividing the portfolio’s return when the benchmark (Bloomberg U.S. Aggregate) performance is positive by the return of the benchmark during the same periods.

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

Larry Cordisco

Co-Chief Investment Officer – Core Equity & Portfolio Manager

Carl Kaufman

Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income

Written by

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

John Osterweis

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

After graduating from business school, John Osterweis served as a Senior Analyst concentrating on the forest products and paper industry for several regional brokerage firms and later for E.F. Hutton & Company, Inc. In addition to his activities as an analyst, Mr. Osterweis served as Director of Research for two firms and managed equity portfolios for over ten years.

In late 1982, Mr. Osterweis decided to devote himself full time to his portfolio management activities, and in April of 1983 launched Osterweis Capital Management. Mr. Osterweis has served as Director of the Lucas Museum of Narrative Art, Director on the Stanford Alumni Association Executive Board, Trustee of Bowdoin College, Director and Vice Chairman of Mt. Zion Hospital and Medical Center, and President of the Board of Directors for Summer Search Foundation. He currently serves as a Trustee of the San Francisco Ballet Association, Director of the San Francisco Free Clinic, and President Emeritus of the San Francisco Ballet Endowment Foundation, as well as Trustee Emeritus of Summer Search Foundation and of Bowdoin College.

Mr. Osterweis is a member of the firm’s Management Committee, a principal of the firm, and a co-lead Portfolio Manager for the core equity, growth & income, and flexible balanced strategies.

Mr. Osterweis graduated from Bowdoin College (B.A. in Philosophy, cum laude), and Stanford Graduate School of Business (M.B.A. with top honors in Finance).

Larry Cordisco

Co-Chief Investment Officer – Core Equity & Portfolio Manager

Larry Cordisco

Co-Chief Investment Officer – Core Equity & Portfolio Manager

Before joining Osterweis in 2019, Larry Cordisco was a Co-Portfolio Manager of the Meridian Contrarian Fund at ArrowMark Partners/Meridian Funds. Prior to co-managing the Contrarian Fund, Mr. Cordisco was an equity analyst for 11 years, most recently as Vice President of Investment Research for the Meridian Contrarian Fund. Before that he was an analyst within the technology group at Bank of America Securities. He was also a business and technology consultant for Accenture in San Francisco and began his professional career in the public sector as local staff for a member of Congress.

Mr. Cordisco is a principal of the firm and a co-lead Portfolio Manager for the core equity, growth & income, and flexible balanced strategies.

Mr. Cordisco graduated from the University of California, Santa Barbara (B.A. in Political Science), Georgetown University (M.P.P.), and Columbia Business School (M.B.A.).

Carl Kaufman

Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income

Carl Kaufman

Carl Kaufman

Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income

Carl Kaufman joined Osterweis Capital Management in 2002 after almost 24 years in various positions at Robertson Stephens and Merrill Lynch. He has managed the Osterweis Strategic Income Fund since its inception in 2002 and is also the Managing Director of Fixed Income and a lead Portfolio Manager for the Osterweis Growth & Income Fund.

In his management role at the firm, he is responsible primarily for investment matters and is a member of the firm’s Management Committee. He is a principal of the firm.

Mr. Kaufman graduated from Harvard University and attended New York University Graduate School of Business Administration.

Morningstar Rating

★★★★ Ratings Information
The Growth & Income Fund is rated 4 Stars Overall in the Allocation--50% to 70% Equity Category

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For more information about this strategy, please send us an email or call us at (800) 700-3316.

The Fund was rated 4 Stars against 707 funds Overall, 5 Stars against 707 funds over 3 Years, 4 Stars against 647 funds over 5 Years, 4 Stars against 480 funds over 10 Years in the Allocation--50% to 70% Equity category based on risk-adjusted returns as of 9/30/22.

The Morningstar Rating for funds, or “star rating,” is calculated for mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product’s monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period has the greatest impact because it is included in all three rating periods.

© 2022 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance does not guarantee future results.

Opinions expressed are those of the authors, are subject to change at any time, are not guaranteed and should not be considered investment advice.

Standardized performance is available here.

Performance data quoted represent past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Fund may be higher or lower than the performance quoted. Performance data current to the most recent month end may be obtained by calling (866) 236-0050. An investment should not be made solely on returns. The Fund’s gross expense ratio was 0.97% as of March 31, 2022.

Mutual fund investing involves risk. Principal loss is possible. The Osterweis Growth & Income Fund may invest in small- and mid-capitalization companies, which tend to have limited liquidity and greater price volatility than large-capitalization companies. The Fund may invest in foreign and emerging market securities, which involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. The Fund may invest in Master Limited Partnerships, which involve risk related to energy prices, demand and changes in tax code. The Fund may invest in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. From time to time, the Fund may have concentrated positions in one or more sectors subjecting the Fund to sector emphasis risk. Investments in preferred securities typically have an inverse relationship with changes in the prevailing interest rate. Investments in asset-backed and mortgage-backed securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments.

The Bloomberg U.S. Aggregate Bond Index (Agg) is widely regarded as a standard for measuring U.S. investment grade bond market performance.

ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar denominated below-investment grade corporate debt publicly issued in the U.S. domestic market. This index reflects transaction costs.

The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.

Indices cited do not incur expenses unless otherwise noted and are not available for investment. These indices reflect the reinvestment of dividends and/or interest. Historical fixed income index data is provided for informational purposes only, not as an indication of future Fund performance.

Coupon is the interest rate paid by a bond. The coupon is typically paid semiannually.

Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.

Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.

Investment grade bonds are those with high and medium credit quality as determined by ratings agencies.

Yield is the income return on an investment, such as the interest or dividends received from holding a particular security.

The Osterweis Funds are available by prospectus only. The Funds’ investment objectives, risks, charges and expenses must be considered carefully before investing. The summary and statutory prospectuses contain this and other important information about the Funds. You may obtain a summary or statutory prospectus by calling toll free at (866) 236-0050, or by visiting www.osterweis.com/statpro. Please read the prospectus carefully before investing to ensure the Fund is appropriate for your goals and risk tolerance.

Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OSTE-20220913-0592]