Why own any stock if it doesn't pay a dividend? While the S&P 500 and its tracking exchange traded fund, SPY (NYSEARCA:SPY), are up over 15% since the summer lows of last year, and stocks such as Apple (NASDAQ:AAPL), are up over 30% in the last year, dividend stocks have consistently outperformed the broader indexes by a fairly wide margin over the last three years.
Indeed, while many leading dividend stocks, such as Altria (NYSE:MO), Kimberly-Clark (NYSE:KMB), and Wal-Mart (NYSE:WMT), sold off hard in 2009, these stocks are at or near the highest levels these more stable stocks have been at in three years. Many more consumer staples stocks with strong dividends, such as Procter & Gamble (NYSE:PG) and Kraft (KFT), are also close to these stocks' three-year highs.
While, obviously, many leading divided stocks that compose the mutual and exchange traded dividend funds have had strong earnings, these stocks are now trading at historically high valuations. Altria and AT&T (NYSE:T) are trading at 15x next years likely earnings estimates. Procter & Gamble and Kimberly-Clark are trading at similarly high multiples of 14-15x average estimates of next year's likely earnings. While Kimberly-Clark has benefited significantly from the near-term pullback in commodities, analysts are still projecting just mid-single-digit growth for this consumer staple over the next five years.
With each of these leading dividend stocks is yielding 3.5-4.5%, or about 2 percentage points more than what the 10 year treasury is yielding today, it is interesting to see how the market is valuing these companies. Obviously, since most investors who hold these stocks are primarily interested in dividends and income, these stocks seem to be trading off of their cash flows more than each company's respective earnings.
Herein lies the problem: While the market appears to be valuing these consumer staple names by these company's cash flow, the stocks are actually trading more similarly to bonds, with the primary appeal of the asset being the current yield. Essentially, as long as investors are confident the company can pay the dividend, and the yield is more than 2% above the 10 year treasury, dividend investors see the stock price as less important than the dividend income returns the investment offers.
Companies know this, which is why with interest rates at historically low levels, and demand for short-term bonds yielding even 1-2% at historic highs, management at many of these leading consumer staple names are raising dividends with debt, not growing the company's earnings.
Altria recently raised its dividend for the third time in three years, despite the company's actual net income declining now for three years, including five straight quarters. Procter & Gamble had to borrow nearly $2 billion to increase the company's dividend and buyback plan since management is using 95% of its net income for dividends and buybacks. AT&T raised its dividend just over 2%, despite the company's cash flow remaining flat the last three years, and revenue growth of less than 2%.
Even cyclical companies that have raised the company's dividend for the last five years, such as Deere (NYSE:DE) and Freeport-McMoRan (NYSE:FCX), are raising dividend payouts at twice the rate of earnings. Deere recently raised its dividend 7%, despite growing earnings at 4%, and Freeport-McMoRan raise its dividend by 25% despite its net income plunging this year.
Today many leading dividend stocks are raising dividends at twice the rate of earnings, and in some cases, companies are borrowing to raise dividends when earnings are not growing at all. While income investors may argue that if the dividend is not at risk being cut, then how a company raises its dividend is irrelevant, this argument is flawed for several reasons.
First, if companies are dependent on borrowing historically cheap capital to raise dividends, recent dividend increases will likely be unsustainable. Second, if income investors are not millionaires, they can look to fixed income and variable rate annuities for income without significant tax ramifications. If the 10 year yield rises even 1-2%, income investors will be able to buy low-risk corporate bonds at far lower risk than equities, and get inflation indexed returns that will likely be greater than the dividend payouts many consumer staple names offer today. Rising rates will also likely force companies that don't have cyclical businesses to issue debt at higher rates, when demand will for such bond offerings will likely be significantly less than today.
To conclude, while many leading consumer staple names have had strong earnings growth over the last decade, many leading dividend companies are increasingly relying on cheap debt to increase the company's dividend payouts. Today companies can borrow at historically cheap rates, and treasury yields are at historically low levels. Still, with the growth outlook deteriorating and unemployment still high, it remains likely that fiscal and monetary initiative will be taken to drive growth and inflation if the economic recovery does not accelerate. While dividend stocks have been the best performing stocks over the last three years, sometimes past results are not indicative of future probabilities.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.