3 More Considerations for Equity Income Investors
In Part 1, I discussed the massive flows to dividend-paying stocks in recent years, dividend yield’s poor performance1 as an investment factor, and notes of caution for the upcoming rising rate environment. Here are 3 additional considerations and suggestions that address the vehicles most commonly used to access the dividend theme, the popularity of dividend growth, and the importance of valuation in making dividend investments.
3. Be wary of dividend ETFs — they offer less diversification than investors are led to believe.
Financial innovation is a wonderful thing. ETFs are a wonderful thing. But, investor assets are becoming more and more concentrated in specific investment themes, and specific investment vehicles. The dividend theme is particularly susceptible to this phenomenon. Recently, I analyzed the four most popular dividend ETFs to see what names they hold in common. The results are summed up in the graphic below. The largest circles represent an ETF. Each spoke is an individual stock holding and is scaled to its weight across the ETFs. The spokes connect each stock to the ETFs in which it is held. For the sake of simplification, only underlying holdings with a greater than 3% weight receive a ticker label.
Dividend ETF Overlap
Notice that the largest-weighted names (middle of the map) tend to be those that are held in common among all of the ETFs. The stocks that are unique to an ETF tend to be the smallest weights and line the periphery. I was surprised by how similar the popular ETFs are — only 20% of the total weight across the four ETFs is unique. 80% of the assets have at least one holding in common with the other three ETFs. 30% have two holdings in common. And 9% of the assets are held in common across all four ETFs.
Here’s why that matters. Individual investors should realize that when owning popular investment products, their fate is tied to the whims of the masses. These vehicles provide near instant liquidity, which can result in massive and rapid flows out of the ETFs and their underlying stocks. In the three months prior to the December 2015 rate hike, fearful investors withdrew $2.3 billion in assets from dividend ETFs. In the three months following the hike, they withdrew another $4.8 billion. The total net outflows of $7.1 billion represented about 6% of dividend ETF assets.
Yet, from December 15, 2015 (when the Fed raised rates) through September 2016, stocks with strong dividend yield delivered an 18% total return.2 Many a crisis negotiator will impart the advice of “slow it down” in times of stress. We may have gotten to the point where financial innovation, ETFs, have made it a little too easy to hit the sell button.
To avoid this herding mentality, investors should ensure that there is low overlap across dividend-focused holdings. This means diving into individual ETFs and mutual funds to make sure they don’t hold the same investments. One way to do this is to hold strategies with different objectives within the dividend space: U.S. dividends, global dividends, small cap dividends, etc.
4. Dividend growth on its own is not an effective strategy.
As valuations have risen on the highest yielding stocks in recent years, dividend managers are seeking dividend stocks with modest valuations. Dividend growers provide ready access to income and the perception of safety from “reaching for yield”. Unfortunately, they fall short on performance. Quite simply, stocks with high dividend growth over the trailing 5- and 10-years have actually underperformed the market since the mid-1970s on average. There are bright spots in that nearly 5-decade span, but dividend growth has mostly been muddling along since the credit crisis.
Dividend Yield & Dividend Growth — Excess Return (1975–2016)
The chart above looks at the total annualized return of various dividend growth metrics: 1-, 3-, 5-, and 10-year dividend growth. I found that stocks with high dividend growth really don’t offer much on the performance front. Take, for example, stocks with high 10-year dividend growth, they underperform the market by 0.7% while stocks with low 10-year dividend growth outperform.
It is important for investors to recognize that dividend growth on its own is not the most effective stock selection factors. Historically, dividend yield does better than dividend growth, but a theme like valuation reigns supreme. Pairing yield and valuation with quality considerations like balance sheet strength and cash-based earnings helps to insure the dividend is sustainable.
5. Valuation trumps dividends.
Valuations are rising across the board. The market is nowhere near the single digit price-to-earnings (P/E) ratio we saw in mid-2009. Today, it is not uncommon to find investment strategies that aspire to a “value-based” investment philosophy, but carry a P/E ratio greater than 20x. Unfortunately, many of those strategies also fall in the dividend space. A byproduct of the massive flows (about $90 billion since 2009) into dividend focused strategies is that valuations have been pushed higher. In the above analysis of popular dividend ETFs, I found that stocks receiving a disproportionate amount of those flows — stocks with the greatest weights — were more expensive than the lower-weighted holdings. Underlying stocks with a greater than 1% weight were more expensive than stocks with less than a 1% weight on average by between 17% and 37% depending on the value metric used — price-to-sales, price-to-earnings, price-to-cash flow, or price-to-book.
This positioning runs contrary to what we know from the historical record. From 1975–2016, a focus on valuation within the dividend yield theme meant the difference between outperforming or underperforming the market. Below, I narrow the investment universe to stocks falling in the highest-yielding third by dividend yield and then subdividing further to create three high yielding portfolios differentiated by valuation. These portfolios share one thing in common, high dividend yield, but are differentiated by another — valuation. High yield and discounted valuation outperform high yield and expensive valuation by 5.4% annualized.
Dividend Yield Top Tertile — Interaction with Valuation
Excess Return (1975–2016)
At a time when demographic demand for income producing assets is high, dividend investing requires great care. The combination of elevated valuations, and uncertainty as to the path of interest rates are enough to perplex most investors. Further, trends toward ETFs have concentrated flows into a relatively small swath of the overall market. It is important to remember that there are only so many large, high-quality, dividend-paying firms. At some point, even strong-performing companies can become bad investments due to high valuations. Be mindful of the price you are paying for dividend income, be weary of dividend growth unless paired with other time-tested themes like valuation, and do your due diligence on the overlap of underlying holdings in equity income portfolios.
Return to Part 1.
Go to the Webinar (Replay).
- All references to excess out/underperformance in this post are in relation to an equal-weighted universe of “large” stocks that trade on U.S. exchanges and have a market capitalization greater than the overall universe average.
- OSAM calculations, top quintile of dividend yield for global large capitalization stocks.