Friday, September 23, 2016

Dividend stocks look expensive…but does this matter?

I’ve been on a two year quest of consistent dividend accumulation. Recent events are certainly giving me pause.
High-quality dividend stocks have been on a tear for the last couple of years. They have certainly been shelters of safety and consequently out performers as far as stock return over this period of time. I recently posted that my 30 stocks for 30 years, a dividend accumulation portfolio has significantly outperformed the market since its inception.
This portfolio of stocks is up almost 14% compared to the 8% increase in the S&P 500 over 2 years. While that may appear to be a dream outcome, it’s not because for the first time since I have started accumulating these stocks I had significant pause about wanting to make my most recent quarterly contribution.
These type of returns would be great if I was a retiree not looking to make additional investment contributions however given I’m still in the accumulation phase of my life I’m looking to make a substantial number of contributions between now and when I eventually exit the workforce.

Having to do so at points in time where more mature stocks are fairly expensive is not a very pleasing prospect.
A significant development just recently was that Vanguard closed its highly acclaimed Dividend Fund (VIG) to new investors. Why is this significant?
On its surface, it appears a strange move from Vanguard given that new inflows result in additional fees for Vanguard. However when you look for the beneath the surface what’s apparent is that Vanguard has to invest this new capital into these same dividend stocks that have had an extended run.
In putting a pause on new money, that’s sending a fairly negative signal about what it perceives to be the fair value of these dividend stocks.
What’s been happening is that as dividend focused funds have been outperforming and there’s been a flight to quality, these funds have been inundated with new money with investors seeing that the dividend stocks are the apparent path to great long-term performance.
Implicit in Vanguards Dividend Fund closure to new money is that the manager doesn’t see a pathway to a suitable return from deploying new investors money in dividend performing stocks at the expense of long-term return dilution for existing investors in the fund.
Another way of stating this is that existing dividend stocks have run up far too much to earn suitable returns on new money that will be deployed into the fund.
When I look at the P/E ratios of many leading dividend stocks it’s easy to see why Vanguards fund managers have jumped to this conclusion. Leading dividend stocks including Clorox, GE, Lowe’s, Microsoft, Pepsi and Procter & Gamble all are priced at P/E ratios in excess of 20 times earnings for the next fiscal year.
Now these are quality names with very stable revenue and earnings streams. However for the most part they’re all fairly mature, slow growth businesses that will return single-digit revenue growth at best for the medium time.
While earnings-per-share growth and returns on equity look good in many instances it’s because these businesses are high-quality cash flow generating monsters that can retire a significant amount of the shares year after year, which has the effect of still continuing to drive strong growth in earnings-per-share measures.
The real question is whether this subpar revenue growth but strong earnings and cash flow generation should warrant such a high premium to where the market trades and also a premium over what these companies themselves have historically traded at on average over the last five-year.
So what does all of this mean? Well when it comes to dividend stocks I tend to be fairly bullish and the reasons for my confidence and optimism come primarily from the fact that I’ve been able to accumulate a high-quality dividend growth income stream from some very steady businesses that have provided me a rising income stream over a long period of time.
In fact my dividend growth portfolio will be well in excess of $23,000 in dividends in 2016.
I certainly don’t believe that the income stream from any of these high-quality dividend payers that I’ve mentioned in this article will be in any jeopardy once interest-rates rise.
I also don’t believe that there will be a material downward rerating of any of the stocks once interest rates increase.  However I think that one can be reasonably confident that total return from these businesses going forward over the next 10 years will likely be subdued given these businesses are in some cases priced at a premium compared to faster growing businesses in the market.
If total return is your game and outperformance of an index your key barometer I’m not really sure that it makes sense to add additional capital to dividend paying stocks at these levels.
However if growing a high quality income stream over the longer-term remains your primary objective then I don’t believe that current pricing of stocks should deter you from the regular accumulation plan even though most of these businesses are trading near historic highs.
Given the underlying quality of the assets that many of these businesses possess I would venture that investors even at these prices should still be the recipients of the steadily growing yet consistent dividend income stream over the long haul. Admittedly you’ll be getting “less dividend for your dollar”.
I’m still debating my next move as far as deploying new capital in my 30 stocks for 30 years at current prices.

This article was written by Financially Integrated. If you enjoyed this article, please consider subscribing to my feed.

1 comment:

  1. Nice article and I understand your motivation. However, you can also look at it like this:

    Stock price: 50
    PE: 20
    Historical PE: 15
    Dividend: 1,50
    Amount to invest: 1000

    If I buy the stock now, then I get 1000/50=20 shares. That means that I get 20 x 1,50 = 30 in dividends each year which is 3% over my invested capital.

    If the stock market corrects and the stock goes back to a PE of 15, then with all other things being equal the price drops to 37,50. I can buy 1000 / 37,50 = 26 shares which pay me 1,50 for 39 a year which translates to 3,9% dividend over my invested capital.

    In the long term that difference is huge. And if the dividend is growing, then in a % it is growing faster if you bought at the lower PE.

    Because of this I think it still matters when you buy, even if you only buy for income. Try calculating this higher entrance yield with increases over the next 10 years and compare the same to the lower entrance yield.

    For me, I'm not quick in buying at this moment. I have patience. :)


Recent Posts From DIV-Net Members