It is easy to forget that within the past decade savings accounts offered 5%, bond yields were over 5%, and many basic income and dividend investing strategies were unable to offer long-term inflation adjusted returns. Dividend and income based investing is not new, but the unique current interest rate environment, historically high recent levels of volatility, and the particularly strong recent performance of leading dividend stocks has significantly increased interest in traditional income based investing strategies. Many popular dividend stocks such as Altria (NYSE:MO), Procter & Gamble (NYSE:PG), AT&T (NYSE:T), and Kimberly-Clark (NYSE:KMB), have also consistently been the strongest performing stocks in the market over the last several years.
Investors will always face new and old challenges, but certain investing ideas face greater obstacles at specific times. With rates guaranteed to move up in subsequent years, inflation likely to rise at least modestly, and most leading dividend stocks at all-time highs, dividend investors will face new and much more significant challenges moving forward.
Many leading dividend stocks such as AT&T, Altria, and Procter & Gamble, have grown earnings at less than 5% a year on average over the last three years. These and many other companies have consistently relied on cheap capital to raise dividend payments over the last several years. Companies with stable growth and significant assets have consistently borrowed at 1-2%, and management at many companies has raised dividend at more than twice these companies' growth rates. Fixed-income investors will not likely continue to be so generous moving forward if inflation rises even slightly.
Traditional cyclical companies are valued based on reasonable expectations for earnings and revenue growth. Dividend stocks are obviously also valued based on reasonable expectations for future earnings and revenue growth, but many investors in stocks known for consistent dividend payments have income expectations as well. If companies face limited borrowing options and increasing debt payments while inflationary pressures stalls growth, many dividend investors simply seeking stable and solid income will find better alternatives in the fixed-income markets.
Many individuals have suggested that hyper-inflation would result from the significant and unprecedented actions by Central Banks worldwide, while others thought the weak economy would make inflation unlikely for years. As usual, the truth was not at the extremes, with food and energy prices rising consistently but not rapidly over the last several years. The consumer price index also suggests inflation is low but rising at nearly 2.4%.
This is why new valuation concerns will also likely become more important moving forward. Dividend investing in the past several years was easy because interest rates were known to likely remain low for some time, so predicting future dividend growth in stable and well run companies was easier. Likewise, with inflationary pressures low, stable income was sufficient for most investors seeking stable returns with medium to low risk tolerance. If inflation and interest rates begin to move up, the market will likely quickly price in additional rate increases and further increases in prices as well. This will make valuing dividend stocks much more difficult, because investors will likely see many leading income stocks with modest growth such as Intel and Altria as unnecessarily risky in a environment where rates and inflation are rising even slightly.
If rates and inflation begin to rise even modestly there will likely be a paradigm switch in how many leading dividend stocks are valued. The market will assume these companies will be unable to raise dividend payments significantly without accelerating revenue and free cash flow growth, and many consumer staple companies will likely continue to face strong competitive pressure to maintain low prices. Procter & Gamble, AT&T, Altria, Kimberly-Clark, and many other dividend champions, have significant long-term debt, and these companies will both have to borrow less and increase debt payments if rates and inflation begin to rise.
Companies' ability to pay and increase dividends was seen as a strong metric for evaluating the strength of the company's business, but many companies such as Intel (NASDAQ:INTC), and Procter & Gamble, have continued to raise dividend payments as actual non-adjusted earnings have declined over the last several years. Altria's net income has fallen on average over the last three years and Intel's growth has stalled as the company has been unable to refocus the company's growth strategy as the PC market becomes increasingly cannibalized. Procter & Gamble's unadjusted earnings excluding the company's buyback have also stalled, but management continues to increased dividend payments at a high single digit rate.
The problem of simply looking at recent or historical dividend growth is that not all dividends are created equally. Investing strategies are as diverse as the individuals and institutions that employ such methodologies. Most investors seek solid long-term returns, but the goals of investors vary widely by age, risk tolerance, and numerous other factors. The only long-term constant in most markets is change.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.