- Dividend-rich stocks have been investors’ favorite for a long time
- Due to low bond yields, there’s a strong reason to have an overweight in Dividend Aristocrats
- However, recent history shows us that dividends aren’t safe as
- In addition, Dividend Aristocrats are now relative expensive
- Investors should evaluate their exposure towards dividend titles, trend may bend…
Dividend income has always been a key theme for investors. In fact, a large part of total return for stocks in the long run can be attributed to dividends. But that’s not the only reason why investors may love dividend-rich stocks. The group also outperforms the broader market. For instance, the SPDR S&P Dividend ETF (SDY) shows a 277% return since the through of the Great Financial Crisis, compared to ‘only’ 247% return for the classic SPDR S&P 500 ETF (SPY). There’s a strong case for dividends in an era of low interest rates and thus low bond yields. If income is key, high dividends may now prevail over modest interest payments. This case benefits also from policies for progressive annual increases in distributions to shareholders. There are however a couple of factors which could cause a lot of headwind for dividend payments…
Dividend aristocrats surfed a strong wave
The top in the league of yearly distributions towards investors are the Dividend Aristocrats: companies with a long history of increasing payouts. This ‘noble’ group has even an own index and is tracked by the ProShares S&P 500 Dividend Aristocrats (NOBL). NOBL was launched in October 2013 and since its inception, it returned a net 34%. That’s significantly higher than SPY (+27%) and NOBL also beat SDY during this period (+31%). However, due to this strong run, the Dividend Aristocrats aren’t the royal dividend payers as we should expect. The current dividend yield stands at 2.03%, compared to 2.17% for SPY. Nevertheless, SDY is still a stronger income generator with yield standing at 2.54%.
Cracks in dividend track record
The policy of an annual dividend increase faces severe headwinds. In particular companies in the energy and commodity sector, usual with a strong presence within the Aristocrats group, will simply not be able to pay generous dividends if commodity prices remain at current low levels, let alone that annual payments will increase. We already witnessed Rio Tinto cutting its dividend. There’s also a strong argument against progressive annual increases without considering the economic cycles. When business conditions are solid and therefore profits increase, there’s a good reason to call for higher distributions to shareholders. But this may better be based on a certain payout-rate (percentage of profits distributed to shareholders). A bigger problem what we see in the current environment is that when profits decline, companies may distribute too much to shareholders. Sometimes companies will pay dividends from their reserves, just to commit to the dividend promise. This could come at the expense of future investments and/or financial stability.
Investors addicted to yield
But why are investors still willing to pay for Dividend Aristocrats, even when risks are higher and yields lower? A strong argument for investing in this group is the solid track record. An additional benefit that comes from tracking an index instead of picking specific titles is that once a company breaches the conditions, it will be removed from the index. The track record ensures healthy yearly income in a world were other sources of income, such as interest are very low. During the recent history, yields on all types of bonds decreased dramatically. This trend goes long back, even before the GFC. As a result, a lot of assets that are allocated toward income generating instruments are invested in dividend names, preferably the Aristocrats. The backside of the medal is that valuations also increased dramatically. According to textbooks, stable dividend paying companies usually have lower valuations compared to growth stocks, since the latter group will see much higher EPS-growth rates. However, price/earnings-ratio’s for both NOBL as SDY are above that of SPY (18 compared to 17).
There’s another issue. Triggered by low interest rates, a number of companies issued additional debt in order to increase dividend payments. Analysts by Deutsche Bank calculated that Dividend Aristocrats saw a dramatic increase in Net Debt to EBITDA. During the nineties, this group had a 70% lower level compared to the S&P 500 average. However, currently this rate stands at a 10% higher than average level. Also the price/book-ratio increased from a 20% discount to a 100% premium!
No cold turkey, but transition may hurt
If the lofty valuations do not sound alarm bells, a change in interest rates urges to reassess positions. In December, the Federal Reserve decided to increase the key interest rate from the zero bound level. This isn’t too much of a concern with dividend yields still above 2%. However, the yield on 10-year US Treasuries is also rising since mid-February and is approaching the 2%-level fast (now at 1.87%). To be fair, during 2015 the yield on 10-year UST was well above 2%. However, there’s reason to believe we’re now entering a phase of yields trending higher, due to the lift-off by the Federal Reserve. When investors believe yields on bonds will increase in the near future, there’s good reason to rotate out of dividend-titles and into bonds. After all, shares are riskier than bonds and should be rewarded with higher yields. An increase in yields means that prices should go lower.
Era of Dividend Aristocrats might be over
Investors should asses whether their allocation towards Dividend Aristocrats reflects their future view on risk and interest rates. Combined with soft economic prospects, and thus a less compelling perspective for dividend increases, Dividend Aristocrats could face much tougher times.
All data in this article as of March 17, 2016.