Warning Signs Of A 'Lost Decade' - Focus On Dividends

Summary

• The P/E multiple expansion seen in stocks from the 1980s through the 2010s was largely driven by falling interest rates and this is unlikely to persist going forward.
• Interest rates have already hit zero and now seem to be rebounding to a higher level in the face of high inflation.
• Stocks may be facing a “lost decade,” wherein stock prices remain volatile or rangebound for years and years.
• During periods of volatility or rangebound markets, dividends play a more important role in generating returns for investors.
• Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Learn More »

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Co-produced by Austin Rogers

It's no secret that declining interest rates boost stock prices, while rising interest rates tend to push stock prices down. Why is this? There are multiple reasons for this relationship:

• Stocks are valued at least partially based on the level of interest rates and bond yields. When bond yields rise, they become relatively more attractive compared to stocks, and investors sell stocks in order to buy bonds. Likewise, when bond yields fall, stocks become more attractive than bonds, and investors sell the latter to buy the former.

• Falling interest rates give the companies behind stocks a lower cost of capital and lowers interest expenses, while higher interest rates do the opposite.

• Lower interest rates produce more economic activity by spurring consumers to buy more using relatively low-cost financing. Think of the active homebuying market after mortgage rates fell. More economic activity generates more business opportunities for companies, which tends to be bullish for stocks. Higher interest rates tend to do the opposite.

This is why the Federal Reserve pushes down interest rates when the economy is weak: they are trying to stimulate the economy by making borrowing more attractive and by making stocks more attractive than bonds.

The problem is that, for the last 30+ years, the Fed has not been able to normalize interest rates back to their previous level after each round of monetary stimulus. Hence, we find a long-term chart of the 10-year Treasury interest rate that looks like this:

Data by YCharts

This period of falling interest rates has been a massive tailwind to the stock market. In fact, it has pushed up the prices of stocks in the S&P 500 (SPY) faster than earnings in the index have grown, which has resulted in price-to-earnings multiple expansion.

This multiple expansion has accounted for a huge portion of SPY's total returns over the past three decades.

Notice in the chart below that SPY's P/E multiple bottomed out around 1980, at nearly the exact same time as the peak in interest rates.

S&P 500 P/E Multiple:

S&P500 has a historically rich P/E multiple (Multipl)

Meanwhile, as interest rates have fallen, the P/E multiple has risen, resulting in higher and higher peaks during the 2000s and 2010s. The average P/E multiple from roughly 1990 to today has been much higher than the average from 1870 to 1990.

This can be seen even clearer in the Shiller CAPE ratio, which measures stock prices against their trailing 10-year average earnings:

Shiller Cyclically Adjusted P/E Ratio:

S&P500 has a historically rich Shiller P/E multiple (Multipl)

As you can see above, the Shiller CAPE ratio bottomed out at the exact same time as interest rates peaked in the early 1980s, and since the early 1990s stock valuations have been above average.

Though inflation and supply chain snarls have captured the headlines recently, it's important to remember that stocks remain quite richly valued on the whole. Take the SPY price-to-book value, which has dipped slightly from the recent selloff but remains near its highest level since the tech bubble era of the early 2000s.

S&P 500 Price To Book Value:

S&P500 has a historically rich P/B multiple (Multipl)

To be fair, many assert that price-to-book value is not as useful a metric as it used to be.

How about price-to-sales (revenue), then? By this metric, the SPY is more richly valued right now than at almost any time in the last 20 years.

S&P 500 Price To Sales Ratio:

S&P500 has a historically rich P/S multiple (Multipl)

This is the situation with stocks, as the BBB investment-grade corporate bond yield is now higher than the SPY earnings yield (earnings/price), a phenomenon that has not manifested since the Great Recession.

Corporate bonds yield more than the S&P500 (YCHARTS)

This set of circumstances looks extremely precarious for stocks. What is an investor to do in light of this information? There are two temptations that we think investors should avoid:

1. Sell stocks, hold large sums of cash, and wait for a market crash to buy back in. While this may sound like the safest option, it does not account for the very real risk of inflation. As long as high single-digit inflation lasts, it will eat away at the value of static cash.
2. Do nothing. While it is generally a good idea not to overreact to frightening circumstances by over-trading or timing the market, we do think it is a good idea for investors to adjust their portfolios in light of the current situation.

We believe investors should emphasize dividends in their portfolios going forward.

Why? Well, it appears that stocks will likely struggle to gain any upward momentum for the foreseeable future because of already rich valuations as well as the dual headwinds of high inflation and rising interest rates. We may very well be in for a "lost decade" in which stock prices remain volatile or rangebound as companies navigate a more difficult economic backdrop.

Historically, during periods of higher volatility or rangebound stock prices, dividends make up a much higher share of total returns.

Consider, for instance, the last major outbreak of inflation during the 1970s. During that decade, dividends made up a remarkable 73% of total returns.

Dividends are very important during times of market volatility (Janus Henderson)

On the other hand, during the raging bull markets of the 1990s and 2010s, dividends made up relatively small portions of total returns. That is primarily because valuation multiples were rising those decades.

Aside from the 1980s-1990s, which enjoyed the tailwind of dramatically falling interest rates, decades of strong total returns are almost always followed by a decade of lower total returns. It is during these low-return decades that dividends shine.

With that said, let's take a look at two attractive prospects to potentially add to your dividend stock portfolio.

1. Kinder Morgan, Inc. (KMI)

• Dividend Yield: 5.8%

KMI is one of the largest midstream natural gas pipeline and storage players in the United States. The company owns and operates a spiderweb of pipelines across the country with substantial assets around the energy corridor in Texas, where many natural gas export facilities are located.

Kinder Morgan pipeline (Kinder Morgan)

Kinder Morgan business model (Kinder Morgan)

Despite the massive trend toward renewable energy, natural gas appears to have multiple decades of demand ahead, including as a replacement for retiring coal-fired power plants. Exports should become a larger factor as well, as emerging economies such as those in Asia consume more and more natural gas.

About 69% of KMI's contracts are take-or-pay, meaning that revenues are fixed regardless of how much volume passes through KMI's infrastructure. Another 25% of contracts are fee-based and fluctuate based on the volume of the commodity passing through. Finally, 6% of contracts are commodity price-based, which means that revenue fluctuates with the price of the fossil fuel.

KMI expects to grow its distributable cash flow this year by 8% over 2021's number (excluding the positive impact of Winter Storm Uri). In the first quarter, excluding the nonrecurring revenue from Uri, DCF jumped by 16% year-over-year, led by double-digit volume increases in natural gas gathering and refined products (e.g., jet fuel).

Moreover, KMI appears to enjoy a highly shareholder-aligned management team, as ~13% of the company is owned by management.

The well-covered dividend was recently hiked by 2.8% and is set to continue growing in the low- to mid-single-digits going forward.

With a near 6% dividend yield and 5-10% expected annual growth, investors can expect to earn double-digit total returns, and importantly, they will get paid to wait.

2. Urstadt Biddle Properties Inc. (UBA)

• Dividend Yield: 5.2%

UBA is a retail real estate investment trust ("REIT") (VNQ) that owns 78 properties across the New York Tri-State area of New York, New Jersey, and Connecticut. Its properties are primarily grocery-anchored shopping centers and include tenants such as Whole Foods (AMZN), Starbucks (SBUX), AutoZone (AZO), and CVS Health Corp. (CVS):

Urstadt Biddle Properties shopping center (Urstadt Biddle Properties)

They are located in the suburbs surrounding New York City, where myriad urbanites bought homes and relocated during the pandemic.

This affords UBA one of the strongest demographic profiles of any retail REIT in the country.

Urstadt Biddle Properties locations (Urstadt Biddle Properties)

As a sign of UBA's quality locations and strong demographic profile, the REIT enjoys the second-highest average rent per square foot in its peer group.

Urstadt Biddle Properties average base rent is among the highest in its peer group (Urstadt Biddle Properties)

Though pandemic-era lockdowns were stricter in this part of the country than elsewhere, UBA's portfolio has emerged from depressed foot traffic during COVID-19 to boast a significant rebound in store visits.

Urstadt Biddle Properties shopping center traffic has fully recovered (Urstadt Biddle Properties)

On top of a rebounding portfolio, UBA is conservatively managed by members of the Urstadt and Biddle families, who together own about 20% of the company.

Historically, UBA's management team has focused on slow and steady growth, boasting an over 25-year dividend growth record until the pandemic struck. Today, debt makes up only 30% of total assets, and the dividend payout ratio was a mere 72% in the quarter ending in January 2022.

Though UBA did complete one acquisition so far this year, most of the REIT's growth will likely come from leasing up its existing portfolio (currently 93% leased) and raising its rent collection ratio, which remains in the mid-90% range.

Going forward, UBA will likely deliver the same as it has delivered historically: slow and steady portfolio growth and dividend growth. Between the 5.2% dividend yield, low- to mid-single-digit earnings growth, and 10-15% upside to fair value, UBA currently offers investors a double-digit total return profile, and again, you get paid to wait.

Bottom Line

With stock valuations high even as inflation runs hot and interest rates are soaring higher, now is the time for investors to exhibit caution. That does not mean to sell everything and go to cash, and nor does it mean to do nothing and let your portfolio remain untouched.

Rather, investors would do well to observe history and note that the last decade of high total returns and multiple expansion are unlikely to be repeated in the next ten years. Rather, it is more likely that in the next decade, dividends will make up a much higher share of total returns than they did in the 2010s.

This increases our confidence in pursuing our real asset-heavy, high-yield investment strategy.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.