Why own any stocks if they don't pay dividends? Well, while the S&P 500 and its tracking exchange traded fund SPDR S&P 500 Trust ETF (SPY) have rallied nearly 20% since the market low of last year, and stocks such as Apple (AAPL) are up nearly 30% in the last year, the recent sell-off in risk assets has been brutal.
Indeed, starting in early April, as the economic data began to deteriorate, the S&P 500 and the Nasdaq sold off 10%. Still, while the U.S. indexes have held up decently, foreign markets, such as the French and German markets, are off over 30% in the last year.
Cyclical sectors such financials, and industrials, as well as market leaders within these sectors, such as Apple, JPMorgan (JPM), Citigroup (C), and General Electric Company (GE), have sold off over 15% in the last month. Energy stocks such as Chevron (CVX) and Exxon Mobil (XOM) have performed poorly over the last several months as well.
In fact, the only mutual funds and exchange traded funds that did not sell off were dividend funds. Specifically, dividend funds with strong holdings in the consumer staple sector have held up very well, and even gone up, in some cases, during the recent sell-off.
As we can see, dividend stocks have on average outperformed the S&P 500 by around 5% over the last three months. Still, with cyclical stocks in sectors such as energy, financials, and industrials, down 15-20%, dividend stocks have outperformed many cyclical stocks, such as GE and Chevron, by nearly 20%.
Obviously, consumer staples names such as Wal-Mart (WMT), Costco (COST), Altria (MO), and Kimberly-Clark (KMB), are not cyclical companies. A number of these companies, such as Wal-Mart and Kimberly Clark, have also had strong recent earnings reports. Still, while these stocks may continue to rise in the short term, there are several indications the price to earnings ratios of many of these high yielders is the highest it will be for the next decade.
First, the yields on these stocks are now barely more than what many cyclical companies with strong balance sheets who recently reported strong earnings and raised guidance for this year two months ago are paying out. Today, GE and Chevron are currently paying a dividend equal or greater than most leading dividend stocks such as Kimberly-Clark and Walmart. Still, while GE trades at less than 11x an average estimate of forward earnings and Chevron trades at an average estimate of 7x next years likely earnings, Kimberly-Clark trades at nearly 15x forward earnings.
Now, obviously, earnings of cyclical companies moving forward will always be uncertain in a volatile economic environment. Still, GE reported its best quarter in three years - two months ago. While Chevron's stock has obviously declined because of the nearly 30% three month decline in crude prices, oil has rebounded strong after every major sell-off for three years.
GE and Chevron both have payouts ratio that make each company's dividend safe, with Chevron paying out less than 30% of the company's revenues in dividends, while GE's payout ratio of around 44% of expected earnings next year is very reasonable as well. GE also raised its dividend by 13% less than six months ago.
With analysts projecting GE to be able to grow its earnings at around 13% a year over the next 5 years, GE's stock looks cheap, and the company is likely to be able to increase its dividend at a significant strong rate than many leading consumer staples names over the next five years as well. Chevron's earnings are obviously heavily levered to oil prices, but with oil having fallen over 30% in the last 3 months, geopolitical uncertainty in the middle east still high, and emerging markets likely to grow significantly in the coming years, oil prices will likely rebound from today's depressed levels over the long term.
So, with leading industrial and energy companies trading at what historically has been cheap valuations for these stocks, and leading high yielders such as Altria and Kimberly-Clark trading at 14x-15x forward earnings, is there justification for the premium multiple that consumer staple names are getting? I don't think so, and I would argue that these stocks are moderately to significantly overvalued. Analysts are projecting Altria and Kimberly-lark to grow these company's earnings by just 6% on average over the next five years, and analysts are projecting Wal-Mart to grow its earnings by just 8% over the next five years.
Now, of course, the reason many individuals and institutions buy these high yielding companies, is for the dividend, so earnings are obviously not as important to cash flow for many investors primarily investing for the dividend. Still, long term, a company cannot consistently raise its dividend if management cannot grow earnings. GE raise its dividend by 13% because the company showed double-digit growth across most of its industrial divisions. Altria raised its dividend 8% because the company's growth was not as strong. Current dividend payouts on leading dividend stocks are already equal and in some cases lower than what many cyclical stocks are currently paying out as well.
So, why are dividend stocks being given growth multiple when analysts are generally forecasting mid-single digit growth and only average dividend raises going forward? I think it's a perfect storm. In essence, dividend stocks are likely at the highest price-to-earnings ratio these stocks will be at for decades to come for several reasons.
First, dividend taxes are not likely to stay this historically low. Obama has already said he will not renew the Bush tax cut for upper income earnings. While the president has repeatedly made this claim and then backed down to extend the Bush tax cuts because of Republican pressure in the past, Obama knows the tax cuts for the wealthy are not popular for the majority of the country, especially since half the country pays no federal income taxes.
Even if Obama compromises with Republicans on future tax rates, the dividend tax for individuals earners making $250,000 or up is likely to go up at least 5-10% in the next year. While a low capital gains tax has a policy goal to incentive risk and investment, low dividend taxes for high net worth investors provide very little benefit to the overall economy.
Second, the dollar will likely sell off longer term. While I think the problems in Europe and weak growth outlook abroad will prevent the dollar from selling off short term, long term, the U.S. economy will grow slower than most emerging economies, and the U.S. deficit will likely remain high. If the dollar weakens longer term, asset inflation will increase. A strong dollar has created a double incentive in the short term to invest in consumer staple stocks in the U.S., since a rising dollar discourages in commodity based emerging markets, such as Brazil, and also means that the costs for companies with moderate pricing power and significant commodity costs, such as Kimberly-Clark.
To conclude, there are many arguments dividend investors make about why this time will be different. Some argue the premium multiple these stocks are getting is justified because more baby boomers are seeking fixed-income alternatives, some argue dividend stocks are valued at today's prices because of how low growth and inflation will be over the next couple years. Still, while terms such as the new normal are trendy, investing in companies with likely single digit long-term growth rates at price to earnings ratios of 14-15 and dividend payouts less than 4% is a not sound investing strategy.
While the earnings of many cyclical companies will likely be volatile in the coming years, the economy has not re-entered a recession for nearly 3 years, and many leading cyclicals have very strong balance sheets and stable growth prospects. Many cyclical stocks continue to report strong earnings and have strong balance sheets as well. While dividend stocks have been the market's best performing asset class most recently, most cyclical stocks have on average outperformed consumer staple companies over the last three decades.