Bet Against Unfounded Enthusiasm For Dividends - Pay More Attention To Quality

 |  Includes: DLN, DVY, SDY, SPY
by: Diffusion

A company issuing dividends alone does not necessarily mean you should invest. The latest enthusiasm for dividends drove the iShares Dow Jones Select Dividend ETF (NYSEARCA:DVY) to an overvalued state.

A Barron’s blog post reported that $1.1 billion flowed into stock mutual funds last week, and the two top gainers are both dividend oriented. The BlackRock Equity Dividend Fund (MDDVX) pulled in $263 million and another $204 million went to the Federated Strategic Value Dividend (SVAAX).

It appears reasonable for investors to crowd into dividend issuing stocks when growth prospects are shady and the stock market is, well, by some measures dirt cheap. SPY now yields 2.2%, higher than the meager 2% on the 10-year Treasury note. Investors gain better yield by investing in stocks.

Dividend stocks are especially appealing because they sound like a sure bet for investors to collect recurring incomes, and, at the same time, to preserve capitals. But both qualities are questionable.

Prudent investors should care more about the quality of dividends. A reliable dividend stream is ultimately supported by a company’s earning power. If the company’s earning engine stops, so do its dividends. For an extreme example, companies may leverage on their balance sheets, issuing debts to pay dividends. For sure the payout is not sustainable. Even worse, a leveraged balance sheet will increase the probability of going bust in an economic downturn, in which case long term investors will lose their shirts.

On the contrary, a company with reliable earnings that is not issuing any dividend is still a good investment. The retained earnings can be returned to investors in other ways. The company can buy back shares to boost per share value of its stock. It can invest the earnings for future growth. A company will see P/E ratio expansion if its growth is creditable, and investors will benefit from stock price appreciation. Even if the company does nothing with the cash, it resides on the balance sheet and increases shareholders’ equity.

As for preserving capital, a recent Seeking Alpha article by Lawrence Weinman pointed out that dividend stocks are highly correlated to the S&P 500. The 60-day correlation between the DLN large cap high dividend ETF and the S&P 500 has constantly been above 0.9 in past two years, meaning that dividend stocks move in lockstep with the market. If the market collapses, so will dividend stocks. They may still pay dividends, but investors will lose capital.

We consulted our ETF ranking system to understand whether the latest enthusiasm for dividends is justified. Key attributes of the ranking system are listed below. For a brief understanding of our ranking system please read “ETF Ranking: A New Fundamental Approach That Drives Short-Term Return,"

  • The ranking system is based on fundamentals. Individual stocks are ranked by their valuation, financial condition and return on capital. We extended the ranking system to ETFs. The rank of an ETF is calculated to be the weighted average over the ranks of stocks in its portfolio.
  • It has predictive power; we observed that stocks with higher ranks had a strong tendency to outperform those with lower ranks over a period of one week. The data show that moving up 10 rank points translates to an extra annualized return of 1.7% in the past 10 years, it ranks range from 0 to 100. As a matter of fact, the S&P 500 Index returned an annualized 2.5% in the same period.
  • Growth is not fabricated into the ranking system. Stocks whose rich valuation is propped up by their growth potential are not going to have rosy ranks.

We choose the iShares Dow Jones Select Dividend ETF (DVY) to represent dividend stocks. DVY is rebalanced once a year while another popular dividend ETF, the SPDR S&P Dividend ETF (NYSEARCA:SDY), has a higher turnover rate. Some of SDY’s holdings will be classified as short term investments and are subject to a higher tax rate. We believe investors favor DVY more than others.

Rank on 3/1/2011

Rank on 9/1/2011







Click to enlarge

The rank of DVY dropped from 53 on March 1st to 44 on September 1st. Likewise, the rank of SDY dropped from 48 to 44 in the same period. Since 10 rank points translated to an annualized return of 1.7% in the past 10 years, DVY’s almost 10-point drop means its annualized return is expected to fall by 1.7%. Although 1.7% doesn't sound like a big deal, it is about 70% of 2.5%, the annualized return of the S&P 500 in the past 10 years.

We believe the key driver of DVY’s lowered rank is investors’ enthusiasm for dividends that drove DVY overvalued. Remember that valuation is a key component of the ranking system and richly valued stocks or ETFs will see worse ranks.

As shown in the chart below, the DVY:SPY price ratio rose from 0.38 in late February to 0.42 in late August. Interestingly, 0.38 is around the bottom of its 2010 range, and 0.42 is around the top of the same range. Technically, the top of trading range is a strong resistance. Price, or price ratio in this case, often reverses when hitting it.

If the economy is not as bad as expected and the market is going up from here as predicted by the latest Barron’s cover story, we expect to see investors’ enthusiasm for dividends to cool off, and the DVY:SPY price ratio to move lower. Investors can long SPY and short DVY to profit from the move.

Admittedly, being overvalued is never a catalyst for price or price ratio to drop. This is an aggressive call trying to time the top of the DVY:SPY ratio, and timing a top is inherently difficult. Nonetheless, the macro economic trend, fundamentals, and technical conditions are all favorable.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.