The ongoing problems in the UK and global economies have driven many investors into the arms of safe, defensive companies that can generate consistent dividend growth. It’s easy to see why this might be an attractive strategy, given the high levels of uncertainty and volatility in the stock market today.
However, the popularity of safe dividend growth shares has caused some people to ask whether this is the next bubble.
At first glance, it seems that there is. Adam Parker of Morgan Stanley is quoted by Merryn Somerset Webb in MoneyWeek as saying “Defensive stocks are trading near a decade-high relative to their more economically sensitive peers”.
Problems with the ‘bubble’ theory
Like most things, it pays to dig a bit deeper and understand what a bubble really is. The idea of a bubble can be misleading as it suggests that there’s a single, all-encompassing bubble. In other words, a bubble in defensive dividend growth shares may lead some investors to think that all dividend growth shares are in a bubble.
But that’s not how it works.
Markets are made up of lots of individual components, like houses in the housing market and stocks in the stock market. At any given time, there will be some houses, or some stocks, which are overpriced and some which are underpriced. A bubble simply means that there are more overpriced investments in a particular asset class or group than normal.
Even at the height of the stock market bubble in the late 90s, it was still possible to find shares that weren’t part of the bubble.
In fact, bubbles favour the astute stock picker because when the market is in a bubble, simply buying the market through an index tracker is more likely to lead to poor future returns. Stock pickers, on the other hand, can continue to look for attractively valued investments no matter how overblown the market may be.
The same is true today for defensive dividend growth companies. While there may be more overvalued defensive companies than usual, there are still plenty that are very attractive.
Avoiding shares with bubble valuations
The best way to pick stocks in a bubble is to know what to avoid. In the stock market, the most obvious signs of a share price that is ‘too high’ are a high valuation multiple (PE ratio) and a low dividend yield.
A good example of an excellent dividend growth company with a high valuation and low yield is Diageo, a ‘low risk’ favourite of many investors. The graph below shows how Diageo has performed in the last decade.
Diageo 10-year results
This is exactly what investors like to see from their dividend growth investments. A steady stream of growing dividends, covered handsomely by stable and growing earnings. The earnings and dividend growth rate has been around 6.3% a year in the last decade, handily beating inflation.
There seems to be little danger of the dividend being cut or even of growth slowing down. The real danger is in the share price.
The current share price (3rd Aug 2012) is 1,700p. For those who already own these shares, this is great news. It’s a record high and some 50% above the previous peak in 2007 and more than 100% above the bear market low in 2009 of 750p. The price in recent months has skyrocketed.
This elevated price has stretched the long-term valuation multiple to extreme levels. The price relative to the past decade’s average earnings (known as PE10) is almost 30. This is more than double the equivalent measure of the FTSE 100.
The high price has hurt the dividend yield too. It currently sits at just 2.5%, which is about a third below the 3.5% available from a FTSE 100 index tracker.
Investors who like Diageo may say that its future is far brighter than the market average, so the inflated valuation is warranted. However, forecasting the future is a dangerous game, especially when that optimism isn’t borne out by history.
Diageo has grown by approximately 6.3% a year in the last decade. That’s a great performance, well above average, with consistent dividend growth to reward shareholders. But over the same period, the FTSE 100 has grown earnings and dividends by about 6.5% a year, with only slightly less consistency. You can see the graph for the FTSE 100 below.
FTSE 100 10-year results
While the FTSE 100 wavered, it did recover, and dividend growth quickly resumed. This leaves a few key questions for investors:
Does Diageo really deserve a valuation twice that of the FTSE 100? Is Diageo’s 30% lower dividend income worth accepting in the hope of future gains? And finally, what might happen to that lofty valuation if Diageo had a bad year and missed its earnings forecast?
You may ask yourself those questions and still decide that Diageo is a worthy investment. That’s fine. The point is that the questions need to be asked in the first place.
Finding dividend growth shares with attractive valuations
Even in the worst of bubbles, there will still be pockets of opportunity; places where outstanding investments can be found at bargain prices. When it comes to dividend growth shares, the trick is to find the highest quality companies for the lowest possible prices – regardless of whether there is a bubble or not.