Sticking to Growth in Future Income is the Preferred Approach Over Reaching for Current Income
Inauspicious headlines were made overseas in early June when German ten-year government bond yields fell below the once unthinkable zero percent level. Following the British referendum vote to leave the E.U., yields fell further as nervous investors ed to the relative safety of bonds. For those of us who remember when savings accounts actually paid interest, this still seems incomprehensible. German yields are not the first to go negative, from Japan to Switzerland, government debt carries negative rates. To date, there is now $11.7 trillion worth of sovereign debt at rates below zero. Investors are paying for a return of their capital, instead of earning a return on their capital. A lack of domestic economic growth and infation have encouraged global Central Banks to pursue incredibly accommodative monetary policy that push rates lower and lower to encourage economic growth. As rates reach their natural limits, the unintended consequences of negative rates are reverberating across economies and portfolios. Banks nd it dif cult to make money in this scenario and normal rules for credit creation become difficult to assess. Strange headlines including record sales of safes and gift cards in Japan point to the real world repercussions of needing to and low cost places to park cash. These things are hard to fathom in modern economies. These are interesting and uncharted times for sure.
In the U.S., ten-year government bonds trade well under 2%. This is a genuinely rich level when compared to countries like Germany and Japan, but incredibly low on any other standard we have used in the past. Consider that the safest credit on the planet and most liquid security you can access, is now priced for essentially 0% real return after re ecting modest in ation. With such low real returns expected from the safest bonds available, investors seeking current income from their portfolios have been forced to move out the risk spectrum into lower quality credits and into equities. Jason Trennert, Head Strategist at Strategas Research Partners has satirically dubbed this seeming paradox the T.I.N.A. market (There Is No Alternative). When investors start rationalizing riskier allocations because there are no better opportunities that present themselves in short order, the patient long term investor should take notice.
We often look to past periods for help in determining potential outcomes for current situations with similar backdrops. As Mark Twain so deftly put it,
“History doesn’t repeat itself, but it does rhyme.” We think the current investment landscape is summed up well by Seth Klarman, a well-known hedge fund manager:
“There is always a tension in the nancial markets between greed and fear. During the 1980s investor greed frequently got the better of fear, with the result that yield seeking investors, known among Wall Streeters as “yield pigs”, were susceptible to any investment product that promised a high current rate of return, the associated risk notwithstanding. Naturally, Wall Street responded by introducing a variety of new instruments—junk bonds, option income mutual funds, international money market funds, preferred equity return certi cates (PERCs), anything that promised high current yields.”
While this is certainly applicable to today’s environment, it was actually written in a Forbes article in 1992. As it was then, it is now. When purveyors of investment “solutions” start peddling product that magically solve the investment paradox of the day, it’s a red flag. Barron’s recently reported 131 different dividend exchange traded funds (ETFs) have launched since the great recession. Dividend ETFs are not the same as preferred equity return certificates, but we think they may rhyme. To say it again, the patient long-term investor should take notice.
Higher Valuations, Higher Risk
Paying too steep a price for equities is a sure way to lower prospective returns. Said another way, as prices and equity valuations increase, risk increases as well. Seeing a host of new wall street product chasing dividend income raises a caution signal, but we also see conformation in stock prices. Based on current valuations, the deck is stacked against the highest yielding stocks.
Overall market valuation is elevated, as we have suggested in recent commentary. By several measures, the S&P 500 is on the expensive side of history. But looking at the 50 stocks with highest dividend yield in the S&P 500, their valuation is incredibly expensive relative to the other 450 stocks in the index. We have to go back to the 1960s to find a period where high yielding dividend stocks were this expensive. Figure 1 above, compares the average Price/Earnings multiple (P/E)1 of the top dividend yielding stocks in the S&P to the index itself. Those high yielders trade at a 10% premium to the market (1.1x the average stock in the chart above). This is the biggest premium we have witnessed since the late 1960s, and considering over time the highest yielding stocks trade at a discount, we are well over one standard deviation above normal levels. It’s worth repeating, when prices are higher, risk is also higher.
Reaching for the Highest Yield Not the Best Approach Historically
Absent valuation concerns, chasing the highest yielding stocks is not an optimal strategy. Dividend paying stocks have historically outperformed non-dividend paying stocks, but those stocks that have the highest current yield are the worst performers within all dividend payers. We analyzed historical S&P 500 returns from 1986 to the end of 2015 and compared the cumulative return of the stocks in different quintiles of dividend yield (for example Quintile 5 represents the top 20% of stocks ranked by yield of the dividend payers). Over that 30-year time frame, the highest yielding companies outperformed non-payers but were the worst performing group amongst dividend payers (See Figure 2. on top of page Four). Quintile 4, which includes companies with a healthy and above average yield (but not the highest), performed best. That group (Quintile 4) would have turned a hypothetical million dollars invested in January 1986 into near $45 million at the beginning of 2016. This time period was not cherry picked, similar relationships are evident looking at 40 and 50-year time periods.
There are several justifications for why this occurs. Often, investors anticipate dividend cuts in advance and drive the stock prices of weaker companies down (and yields up) ahead of cuts. Those apparent high paying stocks that trim their payout go on to underperform (confirmed by many empirical studies of dividend cutters). A second reason is companies with very high yields are often mature with little prospects for growth. The companies that deliver a growing stream of future income reward shareholders with the highest total returns. As you know, we invest
in companies that are profitable today but also have the best opportunity to grow profits and dividends in the future.
What’s an Investor Focused on the Long-Term to Do?
The bedrock of our investment philosophy rests on buying high quality, pro table companies, that are shareholder friendly with their capital. A consistent track record of dividend payment is often an excellent signal of quality. Given our bent, and with valuations extended, it is even more critical than normal to be selective when choosing investments. Fortunately, at times when bull markets get dif cult, and security selection becomes most relevant, our approach shines the brightest. Income starved investors who buy the newest high yielding products the industry has created would do well to take notice of this disciplined approach.
So what’s our solution? It may sound repetitive for long-time clients, but we believe a more concentrated portfolio of individual companies with strong competitive positions, compelling growth outlooks, and more attractive valuations, offer investors the best chance to earn the highest returns the market will bear.
To highlight a simple example of how this works in practice today, we studied the companies that have produced the highest recent dividend growth. On a relative basis to the average stock in the S&P, dividend growers are inexpensive. As Figure 3. above shows, the 50 companies with highest historical dividend growth are inexpensive compared to the average stock. We don’t believe aggregate market valuations offer signi cant upside at current levels, but we do take some solace that our corner of the market is priced for a brighter future.
Putting it All Together
Seven years into a U.S. economic expansion and bull market, with interest rates at unprecedented levels, it is imperative to continually assess the risk and reward of different investments. The valuations of high yield stocks signal a reminder to avoid reaching for current income at the expense of future income. At these times, it’s more important than ever to stick to a disciplined approach of only investing in companies with competitive advantages and stable business models that we think can generate a growing stream of income for owners in the future. Only with patient, diligent, and concentrated effort can we build portfolios that have those characteristics at attractive prices. Against the backdrop of high prices, this focus will provide the best opportunity for future returns.
Please Note: Examples shown are for illustrative purposes only and do not represent the performance of any account, portfolio, composite of accounts or specific recommendation of Boston Financial Management. Your actual performance will vary based on your particular circumstances and should be adjusted to reflect management fees and trading costs. Investment in securities involves risks, including the risk of loss of principal. Past performance is not a guarantee of future returns. IRS Circular 230 Disclosure: Pursuant to IRS Regulations, we inform you that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.