Dividend investing seems to be all the rage at the moment, with interest rates below inflation and bond prices dangerously high.
Usually, when an investment strategy becomes popular, it’s time for smart investors to look for the exit. So should dividend investors move on to something else?
Two types of dividend investing strategies
There are two broad strategies which come under the dividend investing umbrella.
The first is the trusty old high-yield strategy.
With this strategy, the first consideration, and sometimes the only consideration, is the current yield on offer. If the yield is “high” – however that is defined – then the shares are a potential purchase. On the other hand, if the yield is “low”, then the shares will not be bought, no matter what the growth prospects of the dividend may be.
The second strategy is the dividend growth strategy.
The aim here is to focus on dividend-paying shares, but to put more weight on the ability of the company to grow the dividend in the long-term, rather than just on the current yield. Some dividend growth investors will even buy if the current yield is below the market average.
High-yield investing is never really popular
High-yield investing is almost always a contrarian strategy to some degree, and that means it’s almost never truly popular.
The logic is simple.
When shares are popular, their price is pushed up by demand from investors. When share prices go up, dividend yields go down. Therefore, if a share is truly popular, it almost never has a higher-than-average yield.
That’s why high-yield investors never have to worry (much) about stock market bubbles.
However, there is a caveat. If you’re a high-yield buy-and-hold-forever investor, then you still have to worry about bubbles and the excessive popularity of any shares you hold.
If you buy a high-yielding stock and sit on it for ten years, then there is a good chance that, at some point, those shares will become popular. This will drive the share price up and the dividend yield down.
Your original high-yield share may end up in a speculative bubble, and if you’re excited by the gains, then you may be desolated by any subsequent losses when the bubble ends.
One way to avoid this is to keep an eye on the yields from your shares (both dividend and earnings yields), and if they move below average, then perhaps it’s time to re-evaluate that investment in case it has become overpriced.
Dividend growth is where the danger lies
Dividend growth investing is the current favourite, and that’s not exactly a surprise. Low and negative bond yields are pushing investors into riskier assets, and a relatively safe first step into equities from bonds is to stick with blue chips.
Many solid, high-quality blue chip stocks trade at a premium to the market, and that’s entirely reasonable as they can generate high rates of growth more consistently than the average company.
But how much of a premium is too much? Is the current dividend growth premium too high?
One of the metrics included in the UK Value Investor Stock Screen is Growth Quality. This measures how consistently a company has produced a growing stream of profits and dividends. Blue chip companies tend to have an above-average Growth Quality score.
So what do current valuations tell us about the popularity of dividend growth investing and whether it’s time to get out or stick with this strategy?
The table shows the results from FTSE All-Share companies with a decade of unbroken dividend payments. They’re shown in order from the most consistently growing companies (high growth quality) down to those that have little growth and/or little consistency (low growth quality).
The first thing to note is that, as you’d expect, growth rates are highest for those companies that grow consistently. On the other hand, companies that have little consistent growth have a negative growth rate on average, which of course, isn’t brilliant for a dividend growth strategy.
Looking at valuations, let’s take the dividend yield, as this is an obvious valuation metric for dividend investors. You can see that investors are accepting a lower yield (i.e. paying a higher price) for companies that can generate high-quality growth. Again, I think that’s entirely reasonable and to be expected.
The question is whether or not that premium is excessive.
Looking further down the quality range, it seems that yields grow as quality falls. Again, that’s what I would expect. Investors are less sure of getting higher dividend payments in future from low-quality companies, and so they demand a higher dividend payment today in the form of a higher dividend yield.
Does there appear to be a spike in the valuation of high-quality companies? I don’t think there is. The difference in yield between each range of stocks is 0.4% to 0.5% in each case. Investors are generally paying more for higher-quality stocks, but I don’t think they are overpaying for quality just yet.
What about PE ratios? Although I’m not a fan of PE ratios, they can still be useful when looked at as an average across many stocks, which is what we have here.
You can see that shares of the highest quality companies have the highest PE ratios, and again the pattern is decreasing PE ratios as the quality of the companies goes down.
There is a bit of an anomaly in that the lowest-quality companies have relatively high PE ratios on average. I expect that’s because these companies have quite choppy earnings, and so in any given year, their PE ratios may be quite high simply because the earnings in that year are particularly low. In that case, the dividend yield may, on average, be a better valuation metric.
In any case, the average PE ratio of the highest quality companies (21.6) is about 25% higher than those of the next group of stocks (PE of 17.3), and those in turn are 8% higher than for even lower quality companies (PE of 16).
Conclusion
I don’t think dividend investors should switch to another strategy just yet. High-yield investing is almost never truly popular, and there is scant evidence that most dividend-growth stocks are overvalued.
However, that doesn’t mean that some individual dividend growth stocks aren’t overvalued. I know of several high-quality blue chip stocks, which I would say are very overvalued precisely because they are seen as bastions of safety. But while those companies may be safe, their share prices are not.
One way to avoid overpaying for high-quality, dividend-paying companies is to always keep a close eye on valuations.
If the dividend yield is far below the market average and the PE ratio far higher, then no matter what the quality of the company or how well it performs in the years ahead, your investment returns may prove to be deeply disappointing.
If, however, you stick to high-quality companies at relatively low valuations, your investment returns may pleasantly surprise you.
John
I have to say that using PE as a meassure for valuation is a big folly. One has to think what’s happen with those earnings after the company realise them.
If the majority of them are needed back into the company with a view to get the same value of earnings next year, that company won’t go very far. I have numerous example here, one is Tesco.
A second question is if those earnings are real earnings or accrual earnings. Probably an example is needed, let’s say the company builds a boat and that takes 3 years. If finished in time and within the projected cost, there is a 10% internal return rate. So what the company does, at the end of the first year it books 3.33% as profits. The problem is that usualy these projects don’t finish in time, and usualy the costs are higher. For CEOs, sometimes this is a nice way to manipulate earnings to get their bonus. I have also numerous examples here, Balfour Beatty is one of them, with the share price gliding down.
Investing in high yielding companies is vile, it is hit and miss. One has to think why a company is priced so low by the market. Are those investors stupid not to pick that company up or they believe the dividend is unsustainable and the business model not fit for the future.
Going back to companies that grow, and grow and they are priced high by the market, at least in some people’s opinion. Those companies have a high rate of retun on capital. Compunding works fo them, some getting 20%+ return on reinvested earnings. Result: higher earnings.
When investing more important is predictibility. I prefer to invest in companies I can predict next year earnings, so even if the PE lowers from 18 to 16 I am not worried, the share price is still higher.
Hi Eugen, you’re right, PEs alone are a bad idea. However, in this case I’m looking at average PEs of say 30 companies in each row of the table, so it’s a reasonably useful metric. Also, the other two rows of growth and yield make up the other key returns for shareholders. The total return to a shareholder is a combination of growth (of dividends, earnings and the company in general), dividend payments, and changes to the PE ratio over time, so I’m not valuing stocks on PE, I’m valuing them on a combination of growth, dividend yield and PE.
One thing I find interesting about the results is that investors are effectively loosing say 0.4% in dividend income in order to gain about 4% in annual growth by picking high quality companies. That seems like a decent trade to me.
That seems to agree with the general finding that high quaity, “low beta” stocks outperform over time, which I agree with.
So overall I agree with the general thrust of your comment, which is that high quality companies are generally a better place to be, and do deserve a premium price, AND that currently, although popular, high quality blue-chip stocks are far from overvalued as an asset class.
Also, I don’t use PE as a valuation metric in general, I prefer to use the cyclically adjusted PE10 instead as it’s a much more consistent signal of value than the current PE.