Dividend Hunting - The Perils Of Blindly Chasing The Yield

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Includes: COH, CPB, KMB
by: Timur Mirzaev, CFA

Summary

Blindly chasing dividend yield is perilous;

By investing in dividend-paying companies, investors should look at each stock from the total return perspective;

Total return of any stock can be decomposed into dividend return, EPS growth, the percentage change in the P/E ratio, and the interaction term;

Despite negative EPS growth history, dividend-yield-chasing investors may have significantly driven share prices up, as judged upon P/E expansion;

P/E ratio correction may substantially drive down share prices, potentially wiping out any income earned.

All too often, we can hear people talking about established and great companies providing high dividend yields. In the low interest rate environment, investors then chase those yields and fail to consider the potential risks. In this report, I am going to digress from my usual approach in valuing a single company. Instead, I will take a group of established companies, based on certain criteria, and show why dividend hunting - even with exceptional companies - has risks easily identified but largely ignored.

The Criteria

Before I dip into the selection criteria I used to screen stocks, I would like to stress out that there is a stark difference between valuing a company (using fundamental drivers of stock value) and pricing it (such as using price multiples). Since I will focus on what impacted price appreciation for the selected group of stocks during the last five years, value drivers (such as free cash flow) will not be considered.

To begin, stock investing - even for seekers of income in the form of dividends - must be considered on total return perspective; that is, dividend and capital gains (It is not a revolutionary new concept but even with this knowledge many investors fail to properly consider their investment decisions). Capital gains, in turn, can be decomposed into earnings growth, the percentage change in the P/E ratio, and the interaction term between the two:

Formula 1

Click to enlarge To see it all in numbers, I ran a stock screener on consumer goods sector (for it has clearly pronounced brands) with the following criteria, some of which are taken to an extreme level on purpose:

  • US-based companies in the consumer goods sector;
  • Negative 5-year EPS growth;
  • Dividend payout ratio of more than 0;
  • P/E ratio of greater than 20x;
  • Market capitalization of more than $10bln.

The screen resulted into a relatively short list of 11 companies. Apart from the abovementioned criteria, all these companies share a long history of growth (but, being mature, limited future growth) and an established brand. The table below provides my screen output:

Table 1

Click to enlarge

The results

With this list of companies, we are now able to collect the necessary data for the Formula 1 above to carry out the computations. Please note that from what will follow, I use five full years of available data (I ignore quarterly data but will still provide it for reference):

Table 2

Click to enlarge

The last three columns from the table 2 are presented for reference on TTM (twelve-month-trailing) basis. (Note the red EPSt figure of $0.1 for ConAgra Foods: the actual EPS at FY'16 for the company is a negative $1.57, which renders any computations not meaningful. In order to get any sense of the growth magnitude, I manually adjusted that figure to the smallest possible positive value). Furthermore, all the calculations that follow are going to be based on annualized basis; for example, 5-year EPS growth will be computed as:

Dividend return, meanwhile, has been approximated by the following formula:

Click to enlarge

In the table below, I provide the results of my computations:

Table 3

Click to enlarge

As can be seen, over the last five years each company in the list provided decent dividend return as well as handsome capital gains, as can be judged upon total return figures. However, a look at the EPS growth rate and the percentage change in the P/E ratio (the figures behind capital growth) shows that despite declining earnings, each company's P/E ratio has expanded significantly during the 5-year period (the only exception in this list is Coach (NYSE:COH), which has, indeed, experienced a drop in the share price). One possible explanation for this worrisome trend may be connected to the fact that investors, chasing attractive dividend yields provided by these companies, have driven shares upward, ignoring the negative EPS growth. As a result, given the size of each company and little room for any further substantial growth, this expansion in the P/E ratio is unsustainable and, once there is a downside correction in the price-earnings multiple (which currently stands above 20x for each company, compared to the historical S&P500 median value of around 15x), investors chasing yield will suffer capital losses, which may potentially wipe out all the earned income or, even worse, go deeper into the red. To put it into perspective, I assume that dividend return will stay the same for each company; earnings growth will average out the 1.74% (current 10-Year Treasury rate), given that each company in the list may be deemed as in steady-growth; and the percentage change in the P/E ratio, assuming contraction to 15x for each company. The Table 4 provides an overview of the previously reported price figures at beginning- and end-periods, current prices, estimated correction value, and the resulting price, given the correction.

Table 4

Click to enlarge

As I mentioned previously, I do not aim to value any company, and the figures presented in the last column of table 4 merely intend to price-in the effects of the potential drawdown, which turns out to be significant. It is interesting to note that while most companies' share prices either continued to appreciate or remained flat during 2016, those of Kimberly-Clark (NYSE:KMB) and Campbell Soup (NYSE:CPB) have already begun the correction, and those of Coach continued their downward slide.

Summary

Investing in companies providing a steady stream of dividends is an attractive proposition for income-seeking investors. Yet, blindly chasing yield has inherent risks that some investors may fail to consider. In this report, I have shown what risks investors face and how to compute and incorporate them for more-informed investment decision-making. With these tools at their disposal, I hope investors will be able to shed light for themselves on whether historical total returns have exhibited sustainability and what they can expect in the future by investing in companies of their choice.

P.S. Interested readers may refer to my Excel file with all the computations behind each table, which I have made available through Dropbox link here.

Disclosure: I/we 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.