At a time when demand for income generating assets is at an all-time high, the yields on income generating assets are at, or near, all-time lows. While the headlines often speak to the number of Baby Boomers entering retirement, the more important statistic is actually the amount of wealth entering retirement. According to the U.S. Census Bureau, of the 125 million households in the U.S., 32% fall between the ages of 55 and 70. That group also represents a disproportionate 57% of median household net worth. Assuming these retirees and near-retirees started saving around age 30, that would place the beginning of their “investment memory” somewhere between 1976 and 1991 and continuing to the present. That entire span was encapsulated by arguably the greatest bond bull market ever, and some of the most robust equity returns in history.
As this cache of wealth is in or approaches the distribution phase of the investment lifecycle, the thirst for income generating assets will be unquenchable. Most retirement models are predicated on a 4% annual withdrawal from retirement assets. In a world of sub-2% equity and bond yields, such a large annual withdrawal seems optimistic and susceptible to substantial sequence-of-return risk.
Though this cohort lived through a golden age of financial asset return, they have also experienced the most dramatic bear markets since the Great Depression. The tech bubble in the early 2000’s and financial crisis of the late 2000’s marks the first time two greater-than 40% downturns occurred in a ten year span, again since the Great Depression. An adaptation of the old adage, twice bitten thrice shy, may appropriately describe many investors.
McKinsey captured the outcome of this phenomenon in a recent report, which suggested that investors are laser focused on: 1) protecting principal, 2) hedging against severe downside risks, 3) minimizing volatility and 4) generating income. While the active management industry has been toiling to identify yet uncovered sources of alpha, investors seem to just want a reliable combination of principal protection and income generation at a reasonable fee. Investor sentiment has shifted, for now, from performance to solutions-focused objectives.
ETF assets confirm the popularity of at least two of these preferences (chart below). The most popular ETF categories, outside of the broad shift to market-cap weighted passive vehicles, are low volatility and dividend-focused.
While equity income could never be a substitute for the principal stability of fixed income, it does offer compelling long-term income generating potential. With equity yields at or higher than yields on most 10-year government bonds, they are no doubt becoming an increasingly popular component of retirees portfolios.
Five considerations for seeking dividend income
Dividend investing requires great care, particularly in the current environment. The combination of poor recent performance, elevated stock valuations, and uncertainty as to the path of interest rates are enough to perplex most investors. In speaking with advisors and clients across the country, we have identified five key considerations for equity income investors.
Dividends performed terribly in the years preceding 2016; that’s a good thing
We have just emerged from a period when stocks with strong dividend yield have struggled. As an investment theme, dividend yield found itself at the epicenter of three major events that conspired to drive lackluster performance—oil, the US dollar, and US outperformance. The crash in the price of oil in late 2014 took its toll on Energy firms. As oil recovered from its 2008 lows, profitability at large oil and gas exploration and production firms increased. They expanded their dividend programs and dividend investors found solace in the strong dividend yields offered. As oil declined in 2014, these previous darlings of the dividend space sold off. Because oil and the US dollar tend to be inversely related, the US dollar strengthened during this period. For global dividend investors, the strengthening of the US dollar served as an additional headwind to performance. Further compounding the performance issues for globally-oriented investors, persistent geopolitical concerns have resulted in dramatic underperformance of developed international and emerging markets. As of October month end, the S&P 500 was beating its developed and emerging counterparts by around 10% annualized over the trailing three years (even with the recent bounce in emerging markets).
Below is a snapshot of calendar year excess returns for stocks with strong dividend yield and dividend growth. Whether you favored dividend yield or dividend growth from 2012-2015, domestically or abroad, chances are high that performance has been challenged.
It would be easy to cast dividend payers aside for that reason, but know that historically it is very common for investment factors to come in and out of favor. So far in 2016, dividend yield has experienced a solid recovery. The chart below shows the rolling five year excess performance of stocks in the top quintile of dividend yield back to the 1970's. Notice that periods of underperformance are followed by prolonged and/or significant periods of outperformance. If history serves as a guide, its possible the recovery of dividend yield experienced so far this year may continue for years to come.
Certain dividend payers historically buck the rising rate performance headwind
The fear of rising interest rates has been particularly alarming for some investors, most notably back in 2015 as the Fed wavered on when rates would increase. For the most part, the pain inflicted there was psychosomatic. The Fed had actually started tightening as far back as 2013 with the announcement of "taper" (when the Fed started reducing its monthly bond purchases). With some positive recent economic data, rates have again moved higher in anticipation of a hike. The concern now is that interest rate sensitive assets—Utilities in particular—will get torpedoed if the Fed starts raising in earnest.
When we looked at the 12 environments where the 10 year US Treasury rose by 1.0% or greater over a 12 month period, we found evidence to support that suspicion. The Utilities sector underperformed in ten of the 12 environments and had an average underperformance of -8.5% on an annualized basis. Real Estate (REITs) underperformed, but robust data only covers three of the rising rate environments so it’s challenging to draw inference. Beyond REITs, Financials are the second worst performer with banks underperforming by 5% on average across all the periods. On the positive side, Energy and Info Tech did exceptionally well, outperforming by 6.1% and 7.4% on average, respectively. Energy outperformed in eight of the 12 environments while Info Tech outperformed in nine. It’s important to note that these are averages across some very unique periods in market history—from the inflationary death spiral of the 1970’s to the tech bubble of the late 1990’s.
Be wary of dividend ETF’s; they offer less diversification than investors are led to believe
Financial innovation is a wonderful thing. ETF's are a wonderful thing. But, investor assets are becoming more and more concentrated in specific investment themes, and specific investment vehicles. While I have my own thoughts on the concentration in passive investment vehicles, I've found a few assessments to be particularly provoking, such as the one below which discusses the implications of passive investing on corporate competitive behavior.
The dividend theme may be particularly susceptible to this phenomenon of concentration into investment vehicles. In a recent analysis, we 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 of the spokes 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.
Notice that the largest names tend to be those that are held in common between all of the ETF's—those stocks in the middle of the map. The stocks that are unique to an ETF tend to be the smallest weights and line the periphery. We found it quite surprising how similar the ETF's are; only 20% of the total weight across the 4 ETF's is unique. 80% of the assets have at least one holding in common with the other three ETF's. 30% have two holdings in common. And 9% of the assets are held in common across all four ETF's.
Here’s why that matters. Individual investors should realize that when owning the most 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. Because the ETF's have similar underlying holdings, sales out of one ETF can result in price declines for holdings in the other ETF's, creating a downward spiral in a panic scenario. When the Fed did raise rates in December 2015, fearful investors withdrew $30 billion in assets from dividend ETF's in the two months following the hike.
Yet, short-term trigger-happy speculators often tend to be wrong. From December 15, 2015 when the Fed raised rates through 9/30/2016, stocks with strong dividend yield delivered an 18% total return. 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, ETF’s, have made it a little too easy to hit the sell button. Let's slow it down a notch.
Dividend growth on its own is not an effective strategy
As valuations have risen on the highest yielding stocks, dividend managers are seeking dividend stocks with modest valuations. As an alternative to pure yield, dividend growers provide ready access to income and the perception of safety. Unfortunately, they fall short on performance. Quite simply, stocks with the best dividend growth have actually underperformed the market since the mid 1970's on average. There are bright spots in that nearly five decade span, but since the credit crisis, dividend growth has muddled along.
The chart above looks at the total annualized excess return of various dividend growth metrics—1, 3, 5 and 10 year annualized dividend growth. What we found was 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 actually underperform the market by 0.7%, while stocks with low 10 year dividend growth outperform. Further, stocks with low 5 year dividend growth counter-intuitively outperform the market and those stocks with high dividend growth. Dividend growth may expand the opportunity set for income investors, but it is not a panacea.
Valuation trumps dividends
Valuations are rising across the board. The market is nowhere near the single digit price to earnings ratio we saw in mid-2009. Today, it is not uncommon to find investment strategies that aspire to a "value-based" investment philosophy carrying a PE ratio greater than 20x. Unfortunately, a lot 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 analysis of popular dividend ETFs above, we found that stocks receiving a disproportionate amount of those flows—stocks with the greatest weights in the ETFs—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 discounted valuation within the dividend yield theme meant the difference between outperforming the market and underperforming. Below, we narrow the investment universe to dividend stocks falling in the highest-yielding third 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. The price you pay is an all important constant in investment success.
A few suggestions
Thinking about the five considerations outlined above, we have outlined some suggestions for seeking equity income allocations.
- Flows into equity income are not likely to stop anytime soon. There is too much demographic demand for income producing assets. It is important to recognize, however, that there are only so many large high-quality dividend paying firms. The trends towards ETF’s has concentrated flows into a relatively small swath of the overall market. At some point, even the best companies can become bad investments due to high valuations. Be cognizant of the price you are paying for dividend income, and seek discounted pricing even if you have to sacrifice yield.
- Ensure that there is low overlap across dividend-focused portfolios you hold. This means diving into individual ETF’s 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: US dividends, global dividends, small cap dividends, etc.
- As we move into a rising interest rate cycle, it may be prudent to consider shying away from the sectors (Utilities and REITs) that have done poorly in those environments. However, as evidenced by the performance of yield after the December 2015 rate hike, don’t underestimate the total return potential of the dividend theme. Sometimes markets become too pessimistic, which breeds opportunity, as was the case late last year.
- Recognize that dividend yield and dividend growth on their own are not the most effective stock selection factors. Dividend yield does better than dividend growth, but valuation reigns supreme historically. Pair yield and valuation with quality considerations like balance sheet strength and cash-based earnings to insure the dividend is sustainable.
 Calculated based on the number of households by age cohort and their share of the weighted median net worth for households across age cohorts.
 “The $64 trillion question: Convergence in asset management”. Pooneh Baghai, Onur Erzan, and Ju-Hon Kwek. Feb 2015.
 OSAM calculations, top quintile of dividend yield for global large capitalization stocks.