(By David Brickell) Recent months have seen a huge surge of investment into dividend stocks, especially in the United States. A July Wall Street Journal article, "Investors Testing the Limits of Defence", noted that, in the prior three months, traditional dividend-paying industries including telecom (13.7%) and utilities (7.5%) had far outperformed the broad Samp;P 500 (-1.2%). According to EPFR Global, investors have plowed a net $16 billion into U.S. dividend equity funds in 2012, vs. $25 billion withdrawn from non-dividend funds. Some dividend-focused indexes like the Samp;P Dividend Aristocrats sit at or near all-time highs. According to the chief market strategist at AllianceBernstein, Vadim Zlotnikov, investors are paying 25% more for dividend-paying stocks than non-payers, the widest such gap on record:
"Investors are willing to pay an enormous premium for dividends.. it's a pretty crowded trade, but even a pretty crowded trade can work as long as money continues to flow in."
This has led some commentators to question whether a 'dividend bubble' may have started....
What's Driving All This Dividend Lust?
In part, this rush into dividend land can be explained by macro-economics. In light of the persistent Euro crisis and doubts over the China growth story, the fear of a global slowdown is driving investor asset allocation out of economical sensitive sectors like technology into sectors considered more defensive like healthcare and consumer staples, which also tend to pay dividends because of their stability. However, clearly, the other major factor is the weight of retail money moving into the space. This is a function of the desperate hunt for income in a yield starved, low-interest world. In the US, the 10-year Treasury bond is near to record lows, and the average savings account now pays almost nothing. Those who invest for income are now moving up the risk ladder as they are so desperate to secure a decent income stream.
A Herding Crowd?
It's hard to tell if it's causal - or just a response to this trend - but another contributing factor is arguably the rise of Dividend Growth Investing (DGI) as a school of thought amongst retail investors. It's hard to pin down the exact origins of DGI but essentially it has emerged out of the blogosphere, via sites like David Van Knapp's Sensible Stocks and Dividend Growth Investor and the writings of others like David Fish, Chuck Carnevale and Norman Tweed on social finance site, Seeking Alpha.
Dividend Growth Investing involves buying stocks that are committed to growing their dividends over time – and have a track record for doing just that. Rather than selecting shares with spectacularly high yields (as with the Dividend Dogs), the strategy takes a longer term view and incorporates the advantages of compounding through reinvesting dividends to meet its objectives. See here for a sample DGI-esque stock screen.
So far, so sensible. However, as blogger Financial Uproar writes, the proponents of dividend growth investing can sometimes appear somewhat myopic (and arguably even unbalanced) in their focus on dividend growth to the exclusion of other concerns:
"They love about 30 different stocks, and they love the HELL out of them.... As long as a company is growing the bottom line and their investors get that yearly dividend hike, dividend growth investors are happy to buy, all other metrics be damned. Paying $10 for every $1 in assets? THAT'S ALL GOODWILL BABY! Buying at a 52 week high? WHO CARES, DADDY LIKES DIVIDENDS.
In that respect, it's interesting to read some back and forth between the CEO of Seeking Alpha, David Jackson and some of the key advocates of dividend growth investing on the site in the comments of this SA article. Jackson observes:
"I haven't found any other asset class (beside dividend growth stocks) where there are similar causes or indicators of potential overvaluation risk, specifically:
1. macro factors (interest rates, demographics, and tax rates),
2. a significant preponderance of positive articles on SA, with relatively few "challenging" articles,
3. high and rising interest from novice investors... The last times we saw massive rises in novice investor interest ended badly: the housing bubble (when everyone seemed to be dealing in real estate) and the tech bubble (when barbers were recommending tech stocks). I'm not saying we've reached that point with dividend stocks, but if we do, it will be too late"
The herding instinct that can prevail amongst investors and on social media sites is well-documented, so it's interesting to see David Jackon intervene in this way. You can see an interesting response by David van Knapp here.
So is a Dividend Bubble forming?
As Jackson alludes to, the global economy has experienced the bursting of two major bubbles in recent years – the "dot com" bubble and the housing bubble. While it's hard to see much parallel between what we're seeing with dividend stocks today and those events, this is a salutory tale worth remembering, namely that of the so-called Nifty Fifty.
The Nifty Fifty were a group of popular large cap growth stocks on the New York Stock Exchange in the 1960s that soared in the early 1970s, only to come crashing to earth in the vicious 1973–74 bear market. They included stocks such as Xerox, IBM, Polaroid, and Coca-Cola, all of which had impressive growth records, continual increases in dividends (virtually none had cut its dividend since World War II), and lofty market capitalization. This band of stocks apparently outperformed the the Samp;P 500 by 15% a year over a period of eight years, while the wider market went nowhere, and delivered even during the worst bear market of that time.
They became known as "one-decision stocks" – i.e. buy and never sell. Because of their track record,many analysts claimed that the only direction they could go was up. It was not just the public, but large institutions as well that poured tens of billions of dollars into these stocks. At one point, these companies were apparently trading on a collective average PE ratio of 45 times and an average price-to-book of over 8 times!
When the US economy entered a recession in 1973, earnings expectations for the Nifty Fifty turned gloomy and, as a result, share prices fell sharply. The contraction was most severe for the Nifty Fifty stocks, many of which did not return to their highest stock price levels for many years. As Forbes magazine noted after the event:
"What held the Nifty Fifty up? The same thing that held up tulip-bulb prices in long-ago Holland—popular delusions and the madness of crowds. The delusion was that these companies were so good it didn't matter what you paid for them; their inexorable growth would bail you out".
As Fesenmaier observes, a fundamental maxim of investment is that, "A great company is not necessarily a great stock"... At some price, a great company's stock is expensive; at some price, a weak company's stock is cheap.
So is this time different?
With this analogy in mind, it might be argued argue that we are reaching a similar point of irrational exuberance, i.e a period where dividend paying stocks, or a certain sub-set of dividend paying stocks that appeal to DGI investors, are becoming bubble-like in their valuations? Deluded by their quest for yield, are inexperienced investors sleepwalking into a dividend/valuation trap?
So far, this looks to be a stretch. As Dan Kadlec of Time notes, not every rally is not a bubble. Bubbles/investment manias tend to display several characteristics. Usually, investors start buying with the expectation that they will be able to flip the asset to a more willing buyer. This demand is often fuelled by leverage, which magnifies gains, which in turn draws in more buyers. Investors become more and more exuberant, dismissing risks and discarding traditional valuation methods with talk of a "new era" to justify the ascent in prices.
In Kadlec's view, what's happening to dividend stocks now would be analogous to the housing market in, say, 2002.
"That's when the bubble talk began and, of course, a bubble was building. But it took another five years and prices rose another 50% before the bubble burst. Even with the brutal decline since 2007, most who bought real estate in 2002 are about even. The real estate bubble lasted years, the internet bubble for years as well, the dividend "bubble" is still in its infancy"
Valuations don't seem that steep... yet!
Dividend stocks do fortunately have a self-correcting mechanism built in. If the price rises, the yield falls, making the shares less attractive. In theory, that should keep prices from getting too out of line, although the strong focus of DGI investors on dividend growth arguably breaks that link.
In absolute terms, this is not really a low-dividend yield environment. P/Es and valuations may seem stretched relative to many non-dividend paying stocks - but only relative to them. There's very little evidence of dividend stocks selling at absurd valuation multiples (e.g. P/Es north of 30x+).
Instead, most of the US dividend stocks are still said to be the 10x - 15x range, while non dividend payers might be 8x - 12x. Furthermore, according to Empirical Research Partners, aside from the 2009 lows, this is the only time that top non-US dividend payers have traded at less than 10x earnings since the 1990s.
As Rodney Hobson in a Morningstar interview notes, there should be little to worry about in the UK given that there continues to be very juicy dividend yields available from really solid companies.
"4% is the norm... Even Vodafone has been up to 8%".
Sea-change in investor sentiment?
Perhaps what we are seeing is a long-term shift in investor preferences - a return to the old days of the Dividend Discount Model and dividend focused investment approach that preceded the Great Bull Run starting in the early 1980s. And it may be that supply will increase to match this new demand. After all, any positive cash flow company could become a dividend yielding stock and, according to Howard Silverblatt of Samp;P, the dividend payout of the companies of the Samp;P 500 is still only 32% of earnings, versus a historical average of 52%.
Charles Sizemore argues that a greater focus on dividends by companies in response to investor demand would be an unambiguous good:
"the payment of a dividend has a way of focusing management attention and discouraging wasteful empire building. It aligns management with the preferences of long-term investors rather than short-term speculators. And in an age of scandals, dividends, unlike paper earnings, cannot be fabricated".
Of course, at the moment, low yields on bonds make it cheaper for a company to raise capital through borrowing than through enticing equity investors with big dividends.
It could still get ugly...
All of this is not to say that there is not a fair amount of yield chasing going on or that defensive / dividend paying sectors of the market are not becoming relatively expensive. Clearly, there are many reasons why you could see an nasty/painful exodus from dividend stocks:
- Interest rates could rise substantially - since the TMT bubble burst, interest rates have been on a relentless march down but this could reverse as inflation spikes, making dividend yields less attractive (and forcing margin buyers of dividend stocks to sell).
- The macro-economic picture could improve markedly, encouraging money out of defensive stocks
- There could be a structural change in the market (for example, a tax change) that might make it less attractive to pay (or receive) dividends.
- A long-lasting recession could cause seemingly perpetual "dividend growers" to cut or stop increasing temporarily their payments.
Of course, if you see DGI stocks as "hold-forever" investments, this may not matter but for those of us who may need to realise capital at some point, it's more concerning. Still, as UK Value Investor points out, talk of a bubble suggests that there is one all-encompassing bubble but that's not how markets work.
"While there may be more overvalued defensive companies than usual, there are still plenty that are very attractive... A bubble simply means that there are more overpriced investments in a particular asset class or group than normal".
As ever, the most important thing is to focus on robust stock selection methodologies and avoid warning signs such as:
- Soaring valuation multiples (PE ratios) vs. most other sectors or the market generally.
- Low dividend yields in absolte terms (e.g. less than 3%)
- A high risk of a Dividend Trap (we discuss the key signs of a dividend trap here).
- Flashing momentum indicators, such as a trend acceleration relative to the 200-day moving average.
Historic suggest that any good trend - if sustained long enough - is likely to develop bubbly characteristics, as more people jump on the bandwagon. For now at least, it doesn't seem like most dividend investors are speculators (e.g. they don't typically buy on margin and they buy dividend stocks to hold in their retirement portfolios, rather than to flip). In a true bubble, taxi drivers and dinner party guests suddenly become "experts" on the latest trend!
Unless long term interest rates shoot up, it seems likely that the current dividend lust will have a good while longer to run but just remember, when your hair-dresser asks you about yield plays or Dividend Champions, then we're all in trouble...