We have recently experienced a nasty market pullback, which has been focused on dividend stocks. The theory is that higher interest rates will make stocks less attractive presumably because investors will demand higher yields and the most immediate way for a security to produce a higher yield is by lowering the price. Of course, in the short run, anything can happen to a particular stock's price and to the averages in general. The thesis of this article is that most equity yield strategies remain attractive and that the "dividend stock" group of equities is particularly attractive.
1. Interest Rate Perspective - First of all, it is important to keep the recent run up in interest rates in perspective. The 10-year Treasury rate has moved up to 2.14%, but that rate is not particularly high even by post-2008 Crash standards. The table below provides some background of the 10-year rate in the past 5 years. While the rate got very low early this year, its recent run-up still leaves it well below post-Crash highs and is not necessarily the first leg of a long run up to pre-Crash levels. Interest rates are still very low by the standards of all but the most recent history. We are still bouncing around a very low floor and we are not bouncing very high.
|10 Year Rate|
2. Interest Rates and Equity Multiples - In recent years, we have begun to see the dividend yields on major indices reach higher levels than the yields on 10-year Treasuries. This is not a traditional pattern. In fact, until this post-Crash period, dividend yields on the S&P 500 had not been higher than yields on 10-year Treasuries since the late 1950s. The notion that an investor could actually get a higher yield on stocks than on bonds is actually very novel and suggests that equity valuations are actually at a level consistent with a built in assumption of higher interest rates.
This pattern is more striking when we compare earnings yields (the inverse of the price earnings ratio) on stocks with yields on 10-year Treasuries. The popular "Fed Model" in the 1990s suggested that these yields should be equal; if they were equal today, the price-earnings ratio on the S&P 500 would be somewhere between 40 and 50 (getting down to 40 only when the yield on 10-year Treasuries got up to 2.5%). Nobody really believes that this will happen, but a PE of 16.7 is equivalent to an earnings yield of 6%, which towers over the yield on 10-year Treasuries and can be equaled in the bond market only by taking on some unattractive combination of duration and default risk.
3. Dividend Trends - Unlike coupons on bonds, dividends are not static. While we all know that dividends are not assured, there has been an inexorable recent trend toward higher and higher dividends. Recent data indicates that dividends on the S&P 500 have increased by 15.8% in the past 12 months, that dividends on the Dow Jones 30 have increased by 9.1% in that period and finally that dividends on the Barron's 50 have increased by 15.9% in that same period. There is reason to believe that the combination of very strong corporate balance sheets and the resumption of significant dividends by some large traditional dividend payers like Citigroup (C) and Bank of America (BAC) will continue and perhaps even intensify this trend.
Looking at individual companies, the table below provides calendar 2013 estimated dividends, dividends from 10 years ago (2013), the percentage dividend increase during that period, the dividends 10 years from now assuming the same growth percentage as experienced in the past 10 years and current yield for Johnson & Johnson (JNJ), Coca-Cola (KO), Intel (INTC), Kinder Morgan Energy Partners (KMP) and Proctor & Gamble (PG). These companies all kept dividend increases coming through the Crash without missing a beat (with the exception of INTC, which kept its dividend at the same level for 7 quarters and then resumed the historic pattern of increases). The last 10 years may not be a good predictor of the next 10 but the past 10 years include the worst recession since the Great Depression and balance sheets are in much better shape than they were 10 years ago. Historic data is split-adjusted and based on information from corporate websites; current yield is derived from Yahoo Financial; and year-over-year increases in indices are derived from data in the latest issue of Barron's.
|2013||2003||% Increase||2023||Current Yield|
Viewing these numbers, I think that only the projection of INTC is implausible and this is due to the unrealistic projection of the enormous percentage increase in dividends experienced by INTC over the past 10 years which, in turn, is due to the fact that INTC dividends started from a very low base. I would assume that INTC can achieve an increase to $2.00 or more, which is more in line with the percentage increases of the other companies.
4. Interpreting Low Interest Rates - Generally, interest rates on debt instruments of significant duration reflect expectations of inflation and short-term rates over the period of that duration. If investors feel that there will be significant inflation, they will tend to demand higher interest rates. If they believe that short-term rates will increase, they will withhold investment in the hope of reaping the benefits of those rates. As a general matter, inflation and higher short-term rates are highly unlikely unless and until the economy improves, demand increases, markets get tight and prices rise. Thus, an increase in interest rates implies - at least to some extent - optimism about the economy. I must admit that I am not particularly optimistic and think instead that we will muddle along for a significant period of time but macroeconomic predictions in the unprecedented situation in which we find ourselves are very uncertain.
I have heard the argument that current rates are "artificial" and are the product of aggressive Federal Reserve intervention in the economy. There is definitely some truth to this but from an investment perspective, the important question has to be "which way does this argument cut?" If low rates are the artificial product of Fed activity and not the true reflection of investor expectations about the economy, this implies that a "natural" interest rate (whatever that means) would be higher and that expectations about the economy are more optimistic than suggested by current interest rates. This would appear to be bullish for equities and would suggest that the ratio between earnings yields on stocks and interest rates should be lower, which would produce even higher PEs than suggested by the Fed Model. I have not reached this conclusion myself, but the "Fed manipulation" theory of interest rates at least arguably implies higher equity valuations.
5. Financial Engineering - Low interest rates and strong balance sheets create enormous opportunities for large companies to engage in "financial engineering." Per share earnings can be increased by share repurchases as long as the money spent on the repurchases has a lower after-tax yield than the earnings yield of the company. The same is generally true of acquisitions; if the acquired company has a higher earnings yield than the after-tax yield on the debt spent for the acquisition, then a cash for stock acquisition is accretive. There are also opportunities to reduce the interest expense on debt through refinancing - although I would expect that much of this activity has already occurred.
6. Clouds on the Horizon - There are always clouds on the horizon. A smart sailor learns how to read them. It is, of course, possible that the Fed will raise rates before the economy improves and that would certainly be a negative for the market. We could also dip into a deflationary recession. A major bubble could be about to burst. But the ships listed above have been through Hell and High Water and are still not only afloat but moving forward briskly. And do investors really believe that we are about to experience something worse than the 2008-09 debacle (during which none of these companies cut dividends and all but one increased them)?
Over both the long and intermediate terms the stocks listed above are virtually certain to do better than fixed income alternatives. I am long all of these names except KMP, which I own through several MLP closed-end funds due to the tax simplification advantage.