Friday, January 6, 2012

We are not in a Dividend Bubble

I recently read an article titled “ Are we Witnessing a Dividend Bubble?”. While catchy titles like Dividend Bubbles and comparisons to the Nifty Fifty from the 1970's can attract readers, there is little substantive evidence to prove that we are in an actual dividend bubble. Back in 2008 I myself wrote an article where I predicted that record low interest rates might lead to a Dividend Bubble.

The Nifty Fifty was a group of one decision growth stocks, which money managers bought indiscriminately regardless of valuation. When the US economy entered a recession in 1973, the rosy earnings expectations for the high multiple Nifty Fifty turned gloomy. As a result, share prices fell sharply. The contraction was more severe for the Nifty Fifty stocks, many of which did not return to their highest stock price levels for many years.

Dividend stocks are a buy and hold for the long term type investment. Making an assumption about “dividend bubbles” based on relative outperformance in a period of less than one year does not sound convincing. While the Nifty Fifty were also considered a buy and hold type of stocks in the 1970's, the major difference is that dividend stocks are actually undervalued. In addition, few investors actually appreciate the value that dividend stocks offer to investors. Bubbles are characterized by irrational exuberance and chasing of assets regardless of their underlying fundamentals. Given the fact that only few investors appear optimistic about dividend stocks, and that fundamentals appear sound, it is premature to talk about a bubble in dividend stocks.

Given the low interest rates on US Treasuries and Certificates of Deposit (CDs), many market pundits are claiming that investors are purchasing income stocks in an effort to get higher yields on their nest eggs. These investors are supposed to be least sophisticated, and therefore these market pundits are claiming that the “smart money” should do the opposite by ignoring income stocks. While this could be true in some isolated instances, few investors typically hold large amounts of cash in fixed income instruments. Their assets are typically invested in stock and bond mutual funds. In addition, few investors simply purchase income stocks without doing any research. Given the fact that dividend stocks in general offer greater possibility for higher returns in comparison to fixed income, investors who are selling bonds and buying income stocks might be actually doing the right thing for their money. The only scenario where investors who purchase 10 or 30 year US Treasuries will generate a higher return than stocks will be if we have a Japan style deflation for the next two decades.

In my investing, I screen the dividend champions and dividend achievers lists for bargains several times a month. There are usually some overpriced stocks, many fairly priced stocks and a few that are undervalued. On average however, most dividend stocks exhibit similar characteristics to equities in general. Equities are trading at their lowest valuations in many years. Corporate balance sheets are flush with cash, and corporations are earning record amounts. As a result M&A activity is increasing, as are dividends and share buybacks.

Dividend investors typically apply a set of qualitative and quantitative criteria, before committing any funds to investments. As a result, even if a company like PepsiCo (PEP) has a wide-moat and will probably keep raising distributions for the next few decades, it should not be bought when P/E is over 20.

In conclusion, while it might seem that investors are paying more attention to dividend stocks, this has not led to any overvaluation in stock prices. On the contrary, many dividend paying corporations are flush with cash, and can afford paying higher distributions in the future. Most of these dividend stocks are attractively priced at the moment and offer a better risk/reward than fixed income securities. Given this information, there is no evidence to suggest that we are in a Dividend Bubble.


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4 comments:

  1. You are assuming that the current earnings and profit margins are sustainable (rather than at a peak).

    There is plenty of info out suggesting this might be an incorrect assumption.

    Allow earnings to mean-revert to historical trend lines (30% lower) and see what that does to the current P/E ratios, and dividend coverage ratios.

    ReplyDelete
  2. As a regular reader of your blog, it would be helpful to see your stock selection process in more detail. From start to finish, how do you discover the stock, determine it is properly valued, investigate it properly, and decide if it's a good buy at present levels, from your perspective. It would be a good learning experience I think, at least for me. It might be good material for a post in the future, a tutorial if you will. After all, learning is half the fun. Perhaps you have done this before and can repost the lesson.

    Thanks.

    ReplyDelete
  3. The profit margins of many of dividend paying companies are not out of line with their historical averages.

    In general, high quality multi-national large-cap companies are trading at very reasonable prices; especially given the alternatives.

    They don't appear anywhere near bubble territory despite the love fest they've been recipients of in the financial press.

    ReplyDelete

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