Fundamentally: Higher Prices Dim the Appeal of Dividend-Paying Stocks

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Dividend-paying stocks have had a terrific run for the last five years and already have double-digit gains in the first three quarters of 2016.

But as money has been moving out of bonds and into these equities in search of income — dividend stocks are yielding 2.5 percent, nearly a point higher than 10-year Treasury notes — investors find themselves in a quandary.

For one thing, traditional high-yielding areas of the market are trading at frothier levels than in recent memory.

The price-to-earnings ratio for utility shares in the Standard Poor’s 500-stock index, for example, is now 17, based on projected profits over the next 12 months. That represents a 20 percent premium to the sector’s historical average.

“The parts of the dividend market that feel most at risk are stocks that are perceived to be more stable and bondlike, like regulated utilities and consumer staples stocks,” said Ben Kirby, a manager of the Thornburg Investment Income Builder Fund.

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Mr. Kirby said his fund, which beat more than 70 percent of its peers in the third quarter and more than 90 percent in the last decade, has been reducing its exposure to these areas this year.

At the same time, an alternative approach known as dividend growth — which focuses not on high yielders, but on modest payers that are likely to increase their dividends consistently over time — is also running into problems.

The earnings growth rate among companies in the S.P. 500 has been declining for five consecutive quarters, according to Standard Poor’s Global Market Intelligence, and dividends represent that portion of profits that is returned to shareholders.

“It’s hard to believe that there’s a lot of room for dividends to grow in the absence of earnings growth,” said Floyd Tyler, president and chief investment officer at the asset management firm Preserver Partners. “That’s a real headwind.”

Moreover, corporations have just been through an extended stretch in which dividends have grown much faster than their historical average.

Josh Peters, senior portfolio manager for Morningstar Investment Management, pointed out that over the last 12 years, the growth rate for dividends on an inflation-adjusted basis has been 5.9 percent. That is significantly faster than the historical real dividend growth rate of about 2 percent for stocks in the S.P. 500.

Payout ratios — which measure the percentage of a company’s earnings being used for dividends — have been rising. This combination of slowing earnings growth and rising payout ratios is why Mr. Peters said “the golden age of dividend growth is over.”

This leaves investors with few options.

Melda Mergen, head of North American equities for Columbia Threadneedle Investments, said it makes sense to “be as diversified as possible.” She added, “You have to try to balance the growers with the current payers.”

That involves embracing economic sectors that have not historically been associated with dividends.

Take technology. Though the sector has a below-average current yield of 1.6 percent, tech companies are now the second-largest contributor to S.P. 500 dividends, behind the financial sector, based on total dollars returned to shareholders.

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“There are pockets of tech with good cash flow and strong balance sheets,” Ms. Mergen said. “And companies are starting to hear more shareholder demand to have more profits returned through dividends.”

The key, she said, is to look at high-quality companies with strong balance sheets and reliable earnings that — in the event of an economic downturn — will be likely to maintain payouts.

Mr. Kirby also prefers high-quality companies, but he notes that these stocks have been in big demand in recent years. So to find quality businesses that trade at decent prices, investors must be willing to consider economically cyclical companies, which may not be popular with dividend investors this late in the economic recovery.

Take the CME Group, which runs several financial exchanges in the United States, including the Chicago Mercantile Exchange and the Chicago Board of Trade.

“This is a high-quality business with high market share in each of the contracts it trades, so there’s pricing power,” Mr. Kirby said. “And what’s interesting about the stock is that it’s a bit countercyclical.” He pointed out that volatility and fear were usually detrimental to financial businesses. But “whenever investor concerns rise, they hedge that risk with futures and options contracts, so CME’s trading volume can increase in those times,” he said.

In addition to the stock’s 2.2 percent dividend yield, the company often issues a special dividend at year-end, which sometimes can effectively double the yield, he said.

John D. Linehan, manager of the T. Rowe Price Equity Income Fund, said, “In order to be a value-conscious dividend investor, you have to make some sacrifice today, whether that means compromising on valuations, stability of earnings, or the regions where you invest.”

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When Mr. Linehan took over management of the fund nearly a year ago, he began broadening the universe of potential holdings. “There can be more attractive opportunities outside the United States without sacrificing on quality,” he said, noting that foreign stocks now make up about 7 percent of the fund’s assets.

As an example, “we were having problems finding opportunities in consumer staples companies in the U.S. where valuations look stretched,” he said. Yet overseas, he found cheaper stocks like Diageo, the London-based multinational maker of spirits such as Guinness and Johnnie Walker.

Robert Hordon, a manager of the First Eagle Global Income Builder Fund, said he had similar experiences with real estate stocks. In the United States, real estate stocks have shot up since March 2009, raising questions about the sector’s valuations.

“That being said, we are owners of real estate securities outside the U.S., in Asia, where high-quality real estate stocks are trading at more reasonable valuations,” he said. One example, he said, is Mandarin Oriental International, which is based in Hong Kong and owns and operates hotels and residences there, elsewhere in Asia and in other parts of the world.

Mr. Hordon added that the United States market “is a relatively low-yielding stock market anyway.”

What is more, American stocks have outperformed foreign shares for several years, a traditional sign to value-minded investors that better opportunities may exist elsewhere.

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Article source: http://www.nytimes.com/2016/10/16/business/mutfund/higher-prices-dim-the-appeal-of-dividend-paying-stocks.html?partner=rss&emc=rss