Ever more often, we hear that high dividend paying stocks are becoming over-valued. This spring introduced the term quality income to describe a “new investment strategy”. The idea is simple: high quality companies with a sustainable dividend generate the highest return. Straightforward indeed.
But meanwhile we need to become a bit cautious with this principle, as this type of stock, especially in the US has become quite expensive. Over there, a large group of companies have been trading at a price-earnings (PE) of 20, which is quite rich by any standards.
The tree components of the return on an equity investment can be summarized as follows:
- dividend
- growth of dividend
- higher valuation of the stock (multiple expansion)
Since 1970, French equities have generated a return of 5,5 percent in real terms (corrected for inflation). Half of that return came from dividends, the other half from the growth in dividends, with a small negative contribution for lower valuations. In the United Kingdom, the real return was 4,9 percent, coming from a marginally increased valuation, a small increase in dividend and more than 4 percent from dividends paid.
History teaches us that changes in valuation are usually limited (depending on your starting point obviously), dividend growth contributes more, but the bulk of the returns are generated by dividend payments. Are equities still attractive currently? The S&P 500 provides a limited dividend yield of 2,1 percent, with a PE of around 14, which is within the normal range historically.
A much higher valuation does not seem likely. The most important source of returns therefore needs to come from dividend increases. At this point, 402 of the 500 companies pay dividends, which is the highest number since 1999. Especially IT companies pay much higher dividends than in the past, with the sector now responsible for 40 billion dollars of the 275 billion dollars worth of dividends paid in total. That even Apple has started paying dividends proves that there is still plenty of room for further increases.
In Europe, the dividend yield is higher, at 4 percent. Valuations here are also about average, with perhaps some room left for increases. With a limited expected dividend growth, the real return comes down to around 4 percent, in line with the US.
Dividend stocks fall naturally into the “value” category. In terms of changes in valuation, markets tend to prefer either growth or value stocks, depending on the market cycle. While intuitively fast growing companies should have more room to grow dividends, value stocks do tend to pay the higher dividends in practice. The reason for this is a higher capital discipline that is caused by a tighter growth environment for value companies. Growth companies tend to generate a higher cash flow, but also tend to spend the money less wisely on acquisitions, greenfield operations and pet projects that typically dilute the return on capital invested. Capital discipline is key for the creation of shareholder value.
According to Rob Arnott of Research Affiliates, another reason for the higher dividend growth of value indices is the rebalancing method of the indices themselves. Before the rebalancing the growth portfolio has a higher dividend growth (from a lower basis), but this is corrected by the rebalancing itself. Value stocks that have moved up a lot, causing the dividend yield to fall, tend to appear in the growth index. In conclusion, you could argue that dividend stocks can be called attractive once the following criteria apply:
- dividends are high and safe (quality income)
- the dividends have room to grow further
- the stock has an average or (better) low valuation.