We (Still) Believe in Dividends
Published On: March 1, 2018
Written by: Ben Atwater and Matt Malick
Dividend investing has become increasingly difficult, especially thus far in 2018. Through Friday, February 23rd, the S&P 500 posted a gain of 2.94%, while the Dow Jones Dividend Index registered a year-to-date loss.
When stocks are historically expensive, they require a narrative to justify such extremes. As bull markets mature, that narrative becomes more and more isolated to a particular sector or even a particular stock. A fantastical tale can justify any valuation, until it doesn’t.
Although nowhere near as spectacular, in some ways the S&P 500 is revisiting the late 1990s. The S&P Technology Sector is now about 25% of the index, up from 16% at the outset of the bull market. This is in a world where S&P considers Amazon and Netflix to be in the Consumer Discretionary Sector. Add these two behemoths to the Tech weighting and you get a weighting in excess of 28%, not too far from the very brief 35% peak in early 2000, one of the greatest asset bubbles of all time.
Another disturbing bubble indicator is that Amazon stock has accounted for about 30% of the S&P 500’s gains year-to-date. Add three other tech stocks to the list – Microsoft, Netflix and NVIDIA – and these four stocks represent half of the stock market’s year-to-date gains. Make no mistake, that is not a healthy market. A market that truly reflects healthy economic prospects sees leadership from not only tech, but financial, industrial, energy and material sectors.
In recent weeks, the stock market has sold off when the 10-year U.S. Treasury yield gets close to 3%. It is no wonder. After a terrific earnings season, which just ended, and which included a boost to earnings from the recent tax cut legislation, the S&P 500 is selling for 25.49 times trailing earnings. The inverse of this, which is the earnings yield, stands at 3.9%. The stock market is rightfully concerned about the competition that interest rates may soon offer. Why risk a huge stock market drop for a 3.9% earnings yield, when you can buy a 10-year Treasury that guarantees 3%? (Not to say that either offers much value.)
With interest rates continuing their recent ascent, dividend stocks have been selling off because investors see the yield from bonds as a direct threat to the appeal of dividends. We believe this is the wrong reaction to the possibility of a further rise in interest rates. Dividend stocks, especially those companies that increase or grow their dividend regularly, have been the best stocks to own in a rising rate environment, while growth stocks have been the worst. If we see rates rise persistently, we should see dividend stocks begin to do well on a relative basis.
A dollar today is worth more than a dollar tomorrow. The higher interest rates get, the truer this statement becomes. Because a true growth stock rarely pays a dividend, the stock is simply worth an estimate of its future earnings. $100 of earnings in ten years is worth $90.53 at a 1% discount rate, but at a 4% discount rate that same $100 is only worth $67.56 today, about 25% less.
Contrast growth stocks with companies that pay dividends, giving investors money today and the chance to grow that dividend to keep pace with interest rate increases and inflation. Data confirms this common sense analysis. Ned Davis Research has found that dividend-growth stocks outpace non-dividend-paying stocks by about 17% in the three years after the first Fed rate hike. Given the initial rate hike occurred in December of 2015, such a result is almost impossible during this cycle. However, it nonetheless argues for the potential for dividend stocks if rates continue to rise.
Not only are dividend stocks likely to outperform if interest rates continue to rise, but, even more importantly, dividend stocks do two things longer-term – 1) boost returns and 2) offer some downside protection when stocks falter. For these two reasons, we will always be dividend investors. We won’t sellout to accommodate short-term anomalies.
From 1962 through 2016, 82% of the total return of the Standards and Poor’s 500 Index is attributable to reinvested dividends and the subsequent power of compounding. In robust decades for market returns, like the 80s and 90s, dividends accounted for 28% and 16% of returns, respectively. But in a moribund decade like the 70s, dividends accounted for 73% of returns. In a period of negative 10-year returns like the 2000s, the only money an investor saw resulted from dividends.
We believe we are on the precipice of another low-return decade; therefore, dividends will be a vital component of total returns over the next ten years, like they have been historically.
From 1971 through 2016, non-dividend payers returned an average of 2.39% per year, while dividend payers returned 9.09% per year. Again, what is presently occurring in the market is a bubble, not a fundamental reorientation of long-term returns. This time is not different.
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