Monday, January 17, 2022

Future Dividend Income is Not Cheap

Last year was a record for dividend payments in the US. This continues the trend of the past 13 years, which wasn't interrupted even in 2020. I obtained data from Standard & Poor's that companies in the S&P 500 paid more than $500 billion in dividends to their shareholders.

Dividend payments on S&P 500 index increased by 3.62% in 2021, from $58.28 to a record of $60.39. That's the 12th consecutive year of annual dividend increases for S&P 500, meaning that the index itself is a dividend achiever.

Over the past sixty years, payments on the S&P 500 index have generally just trended upwards. The only exception was during the Global Financial Crisis, when payments decreased in 2008. Despite the Covid-19 shutdowns however, S&P 500 dividend payments rose from $58.24 to $58.28. This is impressive growth, given the fact that a lot of businesses worldwide were shut down. During the bleakest days in March and April 2020, forecasters were expecting double-digit decreases in dividends in 2020. So we pulled through.

While dividends kept growing, earnings per share grew faster in 2021. 

Share prices also grew faster than dividends in 2021. As a result, the dividend yield on S&P 500 dropped to the lowest level in 20 years. Those are the days of the Dot-Com bubble for reference. The dividend yield on S&P 500 on December 31, 2021 was at 1.27%.

It looks like the price of future income is definitely more expensive, because dividend yields are lower today. Of course, I can see that as I am trying to look for good quality dividend growth stocks. It is definitely getting harder to find those hidden gems and buy them at a good price today. This is where looking for individual companies may pay off today.

On the other hand, while stocks are not very cheap, there is no alternative really today that can generate and grow investor capital for the long-run either. 

While S&P 500 has a P/E of 24 today, that is equivalent to an earnings yield of 4%, which is better than the 30 year Treasury Yields of 2%.Of course, we should not forget that earnings would likely grow at around 6%/year over the long run, while bond coupons would never grow.

One similarly between today and 20 years ago is the fact that almost a quarter of the market capitalization of S&P 500 index is derived from companies that do not pay dividends. Some of them are the so called FANGs - Facebook, Amazon, Netflix and Google's of the world.  However, the major difference is that the companies with no dividend payments in 1999 - 2001 could not afford to pay dividends, and they were wildly overvalued. In contrast, the largest companies like Apple, Microsoft, Facebook and Google are earning good profits, they are not selling for more than 30 times earnings, and they are growing those profits quickly ( well, sans Apple).

The one major difference between today and the period from 20 years ago is that companies tend to spend more money on share buybacks than dividends. In comparison, companies spend roughly equal amounts on dividends and buybacks about 20 years ago.

This brings me to the next point. While future dividend income is more expensive, that doesn't mean that investors should not be investing. Not investing means timing the market. It also means missing out on the power of compounding. I believe that investors should be investing when they have money to invest, in the best values they can find at the time. 

The current environment definitely shows the importance of focusing on items within your control. While I do not know if a company would do well over the long-run, I can focus on factors within my control.

For example, I can require quality from the companies I invest in. I can require growth in earnings per share, and an adequate coverage in the dividend payout ratio. I can also be somewhat choosy about the valuation as well.

Most importantly, it would also mean ensuring that I keep investment costs low.  If I buy a stock yielding 3%, and I pay a 1% fee to a financial advisor or a mutual fund manager, I am effectively losing a third of income. 

In addition, if I pay a 15% tax on those dividends, I lose out on 15% of income. I can reduce that by prioritizing investing through tax-deferred accounts such as a Roth IRA for example.

Another item within my control is my savings rate. When I earn less in dividend income from the same amount of money as I did before, I should try to cut costs and increase income in order to be able to save more money.

I think that there are good companies at attractive valuations today. Investors who screen their universe can find good opportunities to build a diversified portfolio of stocks today. That's what I am trying to do too in my premium newsletter as well.

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