With yield seemingly the sole focus for many investors nowadays, what we are about to tell you may be hard to believe. Yet there really was a time – and not all that long ago – when a high dividend yield could be taken as a solid indication a business was generally underappreciated by the market. As the following chart clearly illustrates, however, that is currently very much not the case.
Best quintile of dividend yield relative forward P/E ratios (1)
Source: Corporate reports, Empricial Research Partners Analysis, data shown from January 1987 to August 2016. (1)Capitalisation-weighted data
The chart, which was put together by our friends at Empirical Research Partners, shows the highest-yielding companies in the market standing at historically elevated valuations – particularly if financial businesses are removed from the equation. The striking conclusion to be drawn from this is that the market’s demand for income has made dividend yield an unreliable valuation metric.
This is a relatively new development but one that has coincided neatly with the rise in demand for so-called ‘bond proxy’ stocks in the years since the financial crisis. While you might expect to, and indeed will, see the likes of the tech sector among the most expensive parts of the market globally, you will now also find consumer staples, tobacco and other industries traditionally viewed by investors as stable – even ‘safe’.
We have argued before, in articles such as No defence, that there will come a time when the hunt for supposedly safe and stable ‘bond proxies’ will push up their valuations to a point where they can really no longer be considered either safe or stable. And one reason why this will happen, ironically enough, is that the reach for yield has now become the sole driver in a lot of investment decisions – effectively turning once solid and stable stocks into momentum plays.
Making matters more precarious still, the market’s readiness to reward companies with higher pay-out ratios raises the question of how long some businesses can maintain their dividends without impairing their intrinsic value. “Although these stocks are expensive on a number of metrics, they are, by definition, the cheapest ones in terms of dividend yield,” notes Empirical.
A high yield combined with low dividend cover can be a dangerous combination. Given how expensive many of these businesses are on long-term valuation metrics such as a 10-year cyclically-adjusted price/earnings ratio, if dividends are cut, you will not only find a hole in your income but you will probably also suffer a much larger hole in your capital pot because the shares will fall significantly as a consequence.
Such a concern can lead us to avoid some of the very highest dividend-paying companies in the market but, when we do so, it is because ultimately those dividends should not be paid in the first place. In short, here on The Value Perspective, we do not believe it is prudent to reach for the very highest yields when doing so risks our clients’ capital.
We would therefore suggest anyone for whom yield has become the only driver of investment decisions ask themselves the following important question:
“How much sense does a bond proxy’s valuation of 30x or so make once you take away its dividend?”
We do not believe we are going out on a limb in guessing that, for many people buying such stocks, the answer would be: “Not much at all.”
Prudent investment is always a question of balancing risk and reward so, in focusing only on yield, people are ignoring the second part of that equation. That may just have worked when otherwise unloved businesses used higher dividends to attract reluctant investors but, in today’s distorted markets, that is no longer the case.
As such, the value approach of tempering the immediate attractions of a business’s dividend yield with a cool appraisal of its balance-sheet strength has arguably never been more important. As the old adage goes, ‘sometimes a high yield tells you about the reward, but sometimes about the risks you are taking.’