Are We In A Dividend Bubble?

by: Bidness Etc

There has been much talk in the financial press regarding the next big bubble. This time the culprits of the bubble are not some exotic derivatives, rather the good old dividend-paying stocks. The foretellers of the impending doom base their theses on the notion that investors are flocking to dividend-paying stocks, and the valuations are getting ahead of themselves. But as we highlight below, the market is far from being classified as a bubble.

Let's begin by defining what an asset bubble actually is. A bubble can be loosely defined as a sharp increase in the price of an asset with hopes that the process will continue and thereby drawing in a large number of buyers (speculators) who intend to generate profit by passing on the asset to the next fool. Or more accurately, since we know that the price of an asset is equal to the discounted future expected cash flows, a bubble will arise from an inaccurate (unjustifiably high) calculation of expected future cash flows, too low of a discount rate or a combination of both. Indeed, in a market euphoria, investors overlook what the future really holds, and are enamored of the feeling of prices continually rising. So a huge demand for the asset is created, with the use of leverage, where speculators jump on the bandwagon with the intention of flipping the asset for a gain.

When it comes to the world of dividend stocks, the story is different. Firstly, speculators are not at play here. Those interested in investing in the typical dividend-paying stocks have long-term investment horizons who wish to have a steady and safe stream of income. Secondly, the companies offering attractive yields are not some fly-by-night operations, but entities with a history of financial stability and track record of rewarding shareholders with payouts.

According to an article published by Morgan Stanley (NYSE:MS), dividend-paying stocks have outperformed the broad market about two-thirds of the time over the last 40 years. They did so for five years from 2003 till 2007, lagged in the time period of 2009 till 2010, and again outperformed last year. The recent short rally does not warrant the title of a bubble or anything implying a bubble. Moreover, we are of the view that the new-found love for dividend paying stocks by the investing community is in fact the realization of the true potential of this segment of the investment universe.

Dividends have on average represented ~50% of the total equity return and tend to show a lower degree of volatility in a downturn compared with that of earnings. Dividends were overlooked beginning in the 1980s; a period of fiscal prosperity of the U.S. and accelerating technological innovations had created an environment where rallies in the market, and the resulting appreciation in the stocks overshadowed the importance of dividends. In fact, dividend increases or initiations were looked upon as a testimony of unprofitable opportunities in the high-growth market.

Now with yields at historical lows and an uncertain macro environment, investors are on the lookout for relatively high-yielding stocks. As the baby boomers mature and plan for the next phase of their lives, the traditionally safe markets have left them disappointed.

Chart 1: 10-Year Treasury Rate

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Moreover, the dividend-paying stocks also provide a safety net in the sense that the management of a company would not wish to cut its dividends once it has initiated because of the negative signal it sends to the market. Also, these companies with a history of dividend payouts have the cash and financial flexibility to pay dividends even in a market downturn, which adds to their attractiveness.

Chart 2:

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Source: S&P, * an issue decreasing dividend twice a year will be counted twice

As seen above in the chart with data extracted from S&P 500, excluding the great financial crisis, the counts companies cutting or even stopping the payment altogether have been very low. For example, 2010 and onwards, on average there were only 7 counts per year of decreases and almost none of companies stopping the payment. Even during the recent great financial crisis, the number of counts of companies that stopped the payments was low highlighting the fact that dividends remain safe (albeit somewhat decreased) even in the worst-case scenario.

Rise of the Dividend Stocks; are they overvalued?

In 2011, stocks that paid dividend rose 1.4% on average compared to the 7. 6% decline for the non-dividend paying ones, of the S&P 500 companies. Dividends are set to increase to a record $277 million this year for the S&P 500 companies.

Table 1:










Count of Dividend Increases*










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*An issue increasing dividend twice a year will be counted twice

As show in the table above, according to data provided by S&P, the count dividend increase YTD in 2012 is the highest. Although some might point out the current scenario indicating that of a bubble, but consider the fact that the Dow Jones U.S. Select Dividend Index is trading at 13.91x its forward earnings compared with S&P 500 index's 13.5x. Based purely on valuations we do not see any runaway performance and consequently anything that might suggest a bubble. Furthermore, S&P 500 currently has a payout ratio of 30%; well below its historical average of 50%, which in turn means that the $277 million expected to be paid out this year isn't that high after all. Also, bottom up consensus S&P 500 earnings growth in 2013 is estimated to be 12% highlighting that there is substantial room for the companies to keep paying out dividends in the future.

Another factor to consider busting the myth of a dividend bubble is the fact there is an inherent mechanism in dividend stocks where as prices rise, yields fall, which makes them unattractive and helps keep the valuations in line. However, although investors should dispel the fear of a bubble, they should keep an eye for value traps. Investors may be drawn toward high-yielding stocks even when the fundamentals of the company do not warrant such payments. These companies will typically have extremely high payout ratios, made possible by incurring more debt or drawing down their cash reserves. A thorough analysis of the history of a company's dividend, its free cash flows and future obligations needs to be taken into account to form a basic opinion on the sustainability of dividend payments.

To conclude, we believe the current surge in dividing-stock buying does not warrant a bubble because 1) a one-year rally does not warrant a runaway performance, 2) the underlying characteristics of dividend-stock investing does point toward a speculative market (ingredients of a bubble) and lastly the fact that these investments would self correct over time as valuations get overstretched.

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

Business relationship disclosure: The article has been written by Qineqt's Macro Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.