One doesn't have to try too hard to read about the deal of a decade available in large dividend-paying stocks. Barron's made cheap large-caps the cover story last week and followed up this week with a warning about risk in low-yielding corporate bonds after a flood of new money lately. While I often doubt something is right when it is being flashed on the covers of financial magazines, I tend to believe that this is a historical buying opportunity. Last week, I discussed my Conservative Growth/Balanced Model Portfolio, which invests primarily in dividend-paying stocks that are likely to increase their dividends over time, describing what I called a "compelling style for challenging times." Today, I want to lay out some scenarios for how investors might fare between investing in dividend-payers vs. corporate bonds.
One can set up any number of examples, so please keep in mind that this is just one example. In my scenario, the investor has a five-year time horizon. That used to be considered long-term, but these days, five years is an eternity! In any event, our choice will be between a five-year corporate bond or a stock that pays a dividend. In reality, one should assume a portfolio of bonds or stocks rather than single issues.
The corporate bond currently yields about 2.5%. Scary but true. The corresponding Treasury security yields 1.84%, and I am assuming an "A-rated" bond has a spread (margin above Treasuries) of about 66 bps. I am pretty removed from day-to-day machinations of the bond market, so please keep in mind that my example may be a little off (but not much). I found a source of historical yields for 5-year corporate bonds: www.bondsonline.com. The following chart (click to enlarge) gives a flavor for what the yields have done for the past few years:
Again, we are trying to gain perspective and aren't counting on precision. It appears that corporate bonds of this maturity are quite low in yield.
It's highly unlikely that an A-rated corporate bond would default, but there is some chance. We will ignore that possibility. Again, assuming a 2.5% yield (and no reinvestment), it's pretty easy to figure out that our return over the next five years will be 12.5% in total. That return is comprised of interest income, as the bond matures at par.
The overall dividend yields for the S&P 500 are 2.1% roughly. As I described last week, though, it's possible to construct a diversified portfolio of about 2.7%. My model's holdings have experienced growth in dividends over the past few years. So, already it looks like we can marginally beat corporate bonds over the next five years by simply collecting the current yield and hoping that the earnings are similar (or higher) and the valuation similar (or better).
While that's a pretty conservative scenario, it could be worse. It could also be better. With that in mind, what would be some reasonable scenarios beyond no growth and no change in valuation?
- Things get worse
- Things stay the exact same (as described)
- Things get a little better
- Things get a lot better.
For that first scenario, let's assume that the dividend remains the same, but the PE valuation falls by 10%. Let's assume an initial PE of 12. For the third scenario, let's assume that the dividend (and EPS) grows modestly (3% per year) but valuations remain the same. For our final scenario, let's assume that the dividend (and EPS) grows 5% per year and that the PE expands by 10%.
Outcomes
In scenario 1, we collect 2.7% per year, but we take a 10% hit in our price. This leaves a total return of 3.5% (the price decline eats up most of the dividend income).
In scenario 2, our total return is 13.5% over the five years (this assumes no reinvestment).
In scenario 3, our ending dividend yield increases from 2.7% to 3.1% (compared to the initial purchase price). Our total return over five years in this case would be 14.33% from dividends and 15.93% from the modest earnings growth. The total of 30.26% represents a large improvement over the base case and compares very favorably to holding the corporate bond.
Scenario 4 is the one I think is most likely, though probably too conservative in my view. In this case, our ending dividend yield is 3.45% (compared to the initial purchase price). Adding up those increasing dividends as well as the 10% improvement in price on the higher EPS yields a total return of 14.92% from dividends and 27.63% from earnings growth and 12.76% from the PE expansion. The 5yr return in this scenario is 55.31%.
While I think that the last scenario best reflects the likely outcome, I will weight scenarios 2 and 3 most highly and consider scenarios 1 and 4 as outliers. Assigning 15% chances to 1 and 4 and 35% probabilities to scenarios 2 and 3 gives an expected return of 24.14% compared to 12.5% holding corporate bonds.
Here are the scenarios depicted graphically over the five years (click to enlarge):
I think it's pretty clear that absent a depression that lasts 5 years or longer, investors will be better off owning high-quality dividend payers than corporate bonds. When looking for those kinds of stocks, I seek strong balance sheets, reasonable or low payout ratios, historical growth in dividends, earnings and sales and a reasonable valuation.
Disclosure: No stocks mentioned
