In my last article on REITs, I explained to readers that I was not fond of the ubiquitous descriptive "bubble" because there's usually little specificity by authors in terms of how vulnerable an asset may be. Just that "a bubble" exists.
I threw out a 40% decline in price, double the usually threshold definition of a bear market, as a possible bubble benchmark. That was just my attempt to provide some context in the matter when discussing the current REIT environment.
The term bubble has been used so much and by so many over the past many years to describe dividend stocks (and bonds) that it's hard to take anyone who uses it seriously anymore. If you yell fire in the theater so many times, at some point you might prove be correct - but your credibility will be shot in the process.
Overvalued (and, for that matter, undervalued) is another term that tends to be thrown around liberally with factual undertone, yet usually without much concrete support. Don't get me wrong, I like it when analysts have conviction in their beliefs and have reason to back up their claims, however, any forward-looking analysis is really just opinion based on current fact. And the only thing factual in the investment world is that which we can substantiate today, not what might necessarily happen tomorrow.
Calling any security or equity sector "overvalued" based on its current market price is fallacious since the market bears what the market bears. If you don't like the price of a favored company, you don't have to buy it. If you consider the price overvalued enough, you might sell the stock or even sell short. Arguing with the market on a daily basis is a fool's errand. Bond bears have been arguing with the market for half a decade now. Dividend bears seemingly just as long.
So, again, those that use the term overvalued typically throw it out without context into how much price vulnerability is inherent to continuing to hold the asset. Oftentimes the use of the words bubble or overvalued is purely for shock value or in support of opinions that malign dividend-focused strategies, particularly dividend growth strategies.
Intangible equity value is higher today
The average investor is going to have familiarity with P/E ratios, earnings multiples, and other simplistic data that helps to determine equity valuation - tangible value. Using that data alone might cause one to determine that the market or individual equities are indeed more expensive when compared to days gone by. However, these, my friends, are not just unusual times in financial markets, they are historically unique times.
With bank interest laughable and investment-grade bond yields not much better, traditional avenues of cash flow capture have disintegrated into a whole pile of nothing. Though preservationists can still proclaim that cash is king, your reward for investing in a CD is negligible compared to what it once was. Using a playing card allusion, I'd opine cash is king has become cash is jack (expletive omitted), or for those that find bank interest humorous, cash is a joker.
I'm the first person out of the box to caution income investors about buying something that's too expensive or provides too little risk-adjusted return potential. However, if you have been too focused on valuation discipline, it's possible you haven't found much opportunity to buy dividend stocks since we exited the financial crisis. Indeed, "overvaluation" has been opined for at least five years now.
One point I believe critics are missing - and generally never address - is that dividend equity has better comparative value to a portfolio today than it has at any time in history - intangible value we might call it. Competitive yield capture along with the potential for inflation-fighting dividend growth provides heightened portfolio value relative to meager, static bond yields and negligible cash yield.
How much incremental value may be up for question. But it certainly seems logical for investors to pay more for the opportunity to capture a well-covered, growing dividend than settle for something much less (and never growing) in a bond or cash.
If you could own an investment-grade bond and get 6% or an 18-month CD for 5%, the tables would be quickly turned. Why would you pay a premium valuation multiple to own a dividend stock or REIT yielding 3 percent if you could get a higher yield with less risk attached elsewhere? Growth, you may say, but if we assume 8% total return from stocks on average, is it worth the elevated risk to pass up the 5-6% virtually risk-free yield?
Before you come down on me and call me irresponsible for encouraging abandonment of bonds and cash today, let me first say a few things.
I'm not looking to invalidate traditional diversification principles or promote the churn of a cash and bond portfolio into something equity heavy. When a portfolio shifts from cash to bond or from bond to equity, there is additional capital risk being taken. That's a fact.
However, many income-focused investors will be quick to point out that money sitting in cash and bonds right now has little utility and is losing the fight against inflation. That's also a fact.
Different market environments call for different portfolio allocations. Different investment goals call for different portfolio allocations as well.
Risk is a very subjective topic. What may represent risk to one may not represent risk to another. We're all at different stages of life, with different income needs, different piles of capital to work with, and, yes, different views on the future.
The biggest risk is probably the do-it-yourselfer's ignorance of different pitfalls that exist in this unique market environment. As we've experienced just this year alone, the market, from a price perspective, is vulnerable. If a 20% correction and 20% snapback in one quarter isn't representative of that fact, I'm not sure what is.
Investors are becoming bipolar in my view, with little conviction in the future. Probably with good reason.
Global tensions and economic fears are also high. While Brexit-talk seems to have quickly slipped from the tongues of traders, there will undoubtedly be other international hot spots that flare and worries that become exposed. Terror attacks around the globe are occurring with increasing frequency. Domestically, our nation is becoming increasingly divided on a number of angles. That, in and of itself, is a risk for investors.
While upping equity exposure, even during these turbulent times may feel right to the income investor, if you are viewing your equity portfolio through a bullish tunnel, you aren't practicing good risk management. Things can, and will, go wrong. I'd argue that asset allocation should be conducted with somewhat of a pessimistic skew for proactive protection purposes.
Positioning a portfolio assuming that a secular change in interest rate direction won't occur is also a risk. If rates increase, it almost certainly will decrease the relative allure for dividend equity, regardless of bottom-line performance. As we saw in spring 2013, a change of heart in the bond market had deleterious effects on dividend equity deemed most rate sensitive. In most cases, that turned out to be a heavenly buy opportunity by January of 2014.
However, I'd argue that putting all of this together, dividend equity may not be as expensive, on a real basis, as bears might like to think.
Understanding the market's seeming madness
Almost daily there is an article noting that Realty Income (NYSE:O) is representative of investor overindulgence in dividend equity. Some of the recent adjectives in titles about O include: extravagantly overpriced, too good to be true, outrageous, and of course, bubble.
However, analysts are missing the point as to why O is where it is. Honing in on FFO valuation is a mistake because the stock has been tracking the bond market with risk premium attachment. Explaining that is beyond the scope of this article. But rest assured, if the 10-year Treasury moves further towards 1%, Realty Income's valuation will become more "outrageous" to those that fail to see the relation. Conversely, if the 10-year moves to 2%, the stock's next stop will be $60, not $80.
I've come to view O's valuation not as representative of dividend equity overindulgence, but as representative of the realities of today's economy and equity valuation nuances. While we can differ on whether a 1.5% 10-year Treasury or O's 3.5% yield is something appropriate for our portfolios or not, please don't tell me that the stock is overvalued or argue with the market anymore. It is what it is.
If you aren't understanding of why different equities behave in certain ways, you should strive to understand. Another risk for income investors is pretending that they know more than anyone else. While I'll repeat that I love an analyst with conviction, having too much conviction or assuming that you know more than anyone else in the room is a huge risk. Diversification and position size limitation are ways you can put governors on unwavering conviction. Invest without them at your own risk.
Putting Things Altogether
Conventional wisdom has it that as equity valuation by traditional measures rises, investors assume more risk. While that may be true, if one opts for cash or investment-grade bond allocation today, because they view equity valuation as too expensive, their return and cash flow potential plummets. That's also a risk for those that are in a position where capital cannot sit idly by.
One must remember that even when we look today at consumer products companies with 20+ earnings multiples like Procter & Gamble (NYSE:PG) and the like, this is nothing compared to what investors were paying during the tech bubble 15-20 years ago. Cisco (NASDAQ:CSCO) was at 100X earnings and GE (NYSE:GE) was above 40X earnings, just to mention two outliers.
Believe it or not, both companies sit today with stock prices only about half of what they were then. Valuation-wise, Cisco today sells with a low-teens multiple while GE sits about 20.
Unless we fall into some sort of deep recession, which is possible although not likely in my estimation, or bond yields race higher, again not likely in my estimation, I don't see a 40% (bubble) correction in the offing. Based on this year's market action alone, we're clearly vulnerable however for a sharp breakdown. But investors also continue to apply to a buy-on-the-dips philosophy, which we saw both in February and shortly after the Brexit-inspired sell-off. Further indication of just how directionless, yet volatile, the market is at the moment.
If ZIRP lasts longer than anyone seems to think, dividend equity will continue to sell at a premium. Continuing to invest like rates are going to move substantially higher or that a negative event for equities, black swan otherwise, is imminent could continue to be a costly mistake.
I continue to believe that you cannot view this market with reckless abandon even if your bias is for stocks to move higher. While that doesn't mean you shouldn't buy now, it means you need to recognize the vulnerability and construct/manage your portfolio accordingly.
In terms of specific equity, some defensive names to consider come from the food space. Supermarket/convenience retailer Kroger (NYSE:KR) doesn't have blistering growth prospects, but it sells at a reasonable multiple and has room to bump the dividend from the current 1.5% yield. Not as cheap is B&G Foods (NYSE:BGS) with a better than 3% dividend. The company's acquisition of the Green Giant brand along with Le Sueur nearly a year ago has gone far better than expected.
A more aggressive/contrarian thought would be Agrium (NYSE:AGU), a fertilizer producer/marketer yielding nearly four percent. If you really think the fertilizer market makes a sharp come around, then consider Mosaic (NYSE:MOS) or CF Industries (NYSE:CF), yielding 4% and 5%, respectively.
Another contrarian idea comes from the aviation world. Brazilian aircraft manufacturer Embraer (NYSE:ERJ) has been beaten to a pulp over the past year as soft business trends, Brazilian economic issues, and a bribery inquiry have all taken a toll. Still, with its second generation of E-jets on the horizon and a huge backlog of commercial business, I see value here. Things could get worse before they get better, however. Also, this has been an erratic dividend payer, with a TTM run of only about 1 percent.
For fans of high-yield, closed-end option-income funds yielding anywhere between 7 and 12 percent are almost a no-brainer in this kind of environment. I've become partial to the index funds from Nuveen - BXMX, QQQX, and DIAX - and would buy and/or rotate when deep discounts inexplicably wax and wane.
Elsewhere in high yield, I'd buy Apollo Commercial Real Estate (NYSE:ARI), which sells near NAV right now and with a huge 11.4% yield. Once it closes on Apollo Residential Mortgage (NYSE:AMTG), it will be able to accretively rotate that book into CRE situations. I would expect a very healthy dividend hike next year, assuming Apollo is successful in asset migration and re-deployment.
It would be my view that dividend equity is not as collectively overvalued as some seem to think. While there may be herd mentality going on to an extent in certain pockets, there isn't exactly the same thought process that we saw during the tech bubble. However, don't mistake that view as a green light to blindly load up on dividend equity.
As the global economy becomes larger, more complicated, yet arguably more fluid, thanks to technological advance, different kinds of risk - some that might not even be thought of as of yet - come into the picture. Investors need to assess asset and individual security risk on a comparative, comprehensive basis and introspectively determine what's appropriate for their own portfolio.
The uniqueness of ZIRP brings further complication into the matter, with concepts like opportunity cost becoming more tantamount than ever before. Your ability to identify and manage risk, and success in effective/timely allocation of capital, will continue to be both your best defense and offense as the unique economic times in which we live continue to play out.
Disclosure: I am/we are long AGU,BXMX,ERJ,GE,ARI,CSCO,KR,QQQX,BGS,DIAX.
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.
Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.