By David Sterman
For many dividend-paying stocks, it appears as if a "great rotation" has begun.
One of the most lucrative investing themes of the past few years may be coming to an end as interest rates start to rise, heightening the relative appeal of fixed-income assets compared with riskier equities.
The question for investors: As others start to flee, how can you know when it's time to go against the grain and load up on dividend-paying stocks?
Let's be clear: Not all investors think we're on the cusp of a sea change in interest rates. The global economy remains quite weak, with Europe stumbling to find an economic floor and China showing increasing signs of weakness. As long as the global economy is in a funk, some strategists expect that U.S. investors will continue to benefit from an environment of ultra-low interest rates. A few have suggested that bonds may rally anew in coming months as the reality of a still-troubled global economy once again dominates investor sentiment.
But I am not in that camp.
Despite the global headwinds, the U.S. economy is slowly gaining traction. The broad consensus among economists calls for the economy to grow in excess of 2.5% in the second half of this year and approach 3% growth in 2014. Once Europe and China reverse course, the global trade tailwind may become a headwind, perhaps nudging the United States toward 3.5% GDP growth by 2015. Against that backdrop, it's hard to see how interest rates (both short and long-term) can stay near multi-decade lows.
The problem with rising rates -- and the possible diminished appeal they will create for dividend-paying stocks -- is negative capital appreciation. If a stock yields 5% but loses 15% of its value, then investors will be looking at 10% total loss. For instance, the subsector known as mortgage real estate investment trusts (MREITs) has had such a bad month that a year's worth of robust annual dividend payments has already been offset by the month's trading losses.
(For an intriguing discussion of this subsector, read my colleague Chad Tracy's column on MREITs, in which he argues that "most of investors' fears for the future have already been baked into current prices.")
Chad makes an important point about downside protection, citing the balance sheet of Annaly Capital (NYSE: NLY) as support for this stock. Annaly's market value has fallen close to 20% since September, to $12.9 billion. Yet the net value of Annaly's cash and bond holdings exceeds $15 billion. Note that these bonds are carried on the books at par value and will not need to be written down as long as Annaly chooses to hold them to maturity and they don't suffer from fresh defaults.
Can this stock fall further? It could, but over time, it's likely to find its way back to book value simply because management can reinvest the proceeds from maturing bonds into buybacks (which are always accretive when shares trade below tangible book value).
Moving past the MREITs for now (as Chad has covered that group extensively), what kinds of signposts can we look for in other dividend producers that don't use borrowed funds to juice their returns and fuel their dividends?
We can look two to kinds of stocks: first, companies such as AT&T (NYSE: T) or electric utilities, such as Con Edison (NYSE: ED), that sport stable but very slow-growing dividends. The second group: companies with lower yields but a path toward higher dividend growth.
Let's focus on the first group. AT&T might be the kind of slow dividend grower you'd seek to avoid, simply because telecom service providers face huge long-term challenges as landlines get turned off. Sure, AT&T has a solid wireless division, but cracks in the armor are appearing. Earnings before interest, taxes, depreciation and amortization (EBITDA), which stood above $40 billion in 2009, 2010 and 2011, fell to $32 billion in 2012. Although AT&T has managed to boost its dividend for many years in a row, that streak will have to end soon if this company can't figure out new paths to growth.
In contrast, electric utilities like Con Edison are extremely fortunate. They are granted profit-preserving rate hikes by regulators, which enables them to boost their dividend by a modest amount every year.
Still, thanks to the rotation out of dividend-paying stocks, even Con Ed hasn't been spared, with its shares falling nearly 10% since early May. That's pushed the dividend yield up to 4.3%. As a point of reference, that's still above the average yield of the 10-year Treasury note over the past 10 years. Sure, rates moved above 5% for a few years when the economy was booming in the past decade. But few expect to see a booming economy again for quite awhile, which means the 10-year Treasury bond is likely to stay below 4% for the foreseeable future.
Risks to Consider: The Fed's aggressive quantitative-easing programs are expected to wind down in coming quarters. If that unwinding doesn't proceed in an orderly fashion, then the bond market may get routed, sucking funds out of dividend-paying stocks.
Thinking about a 4% Treasury yield is a good marker for these times. As long as a stock yields more than that, and as long as the business has a wide enough moat, then it shouldn't scare you off.
In a follow-up to this column, I'll be looking at a tech sector with current dividend yields typically below that 4% threshold but sufficiently robust growth prospects to create much higher payouts in the years to come.
Disclosure: I am long T, NLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.