Our choice this year of a scary investment theme to mark Halloween is unlikely to come as too much of a shock to regular visitors to The Value Perspective. For some time now, in articles such as No defence, we have argued investors’ insatiable thirst for income has pushed the valuations of supposedly safe and stable so-called ‘bond proxy’ stocks up to truly frightening levels.
A significant reason for this unnerving state of affairs, as we pointed out in Sole driver, is the focus of many investors on dividend yield – seemingly to the exclusion of any other measure of a business’s value. This is worrying because there are plenty of other valuation metrics available – all of which, we would argue, are superior to yield.
Investors could, for example, consider ratios such as a company’s price to earnings, its price to book value or its price to sales, or indeed its enterprise value, which essentially shows a business’s market capitalisation plus debts relative to its operating profit. And there is an enormous amount of academic evidence to show that paying a low price in light of any of these metrics will serve investors well over the longer term.
At this point, we will happily concede there is also a decent body of evidence to suggest that paying a low price relative to a business’s dividend – in other words, doing exactly what much of the market is currently and searching out high yields – can also work in this regard. We would, however, swiftly follow that concession with a ‘but’ and it is a significant one.
Here on The Value Perspective, we do not view dividend yield as a true valuation metric because dividends are discretionary. In other words, it is up to the individual business to decide how much it pays out in dividends each year – and, whisper it quietly – it is not unheard of for companies to decide to pay out a level that is not necessarily helpful to its longer-term health.
A business may, for example, put itself in a position to pay out a larger dividend than it otherwise might by taking on debt or issuing more shares to new investors – neither course of action, in our experience, tends to enhance shareholder value over the longer term. Yet companies nevertheless do so because they know a high dividend can make them more attractive to certain investors – and never more so, of course, than today.
We are seeing more and more examples of both courses of action in current markets, not to mention an increasing desire among businesses to be seen to be paying a ‘progressive dividend’ – one that rises at least in line with earnings per share. That may be realistic for some types of company but, when cyclical businesses now come to us wearing that aim as a badge of honour, we leave them in little doubt they should desist.
Interestingly – and worryingly – as we also noted in Sole driver, the last few years have seen a divergence between dividend yield and other valuation metrics. To illustrate the point, it is worth repeating the following graph, which was put together by our friends at Empirical Research Partners and shows the highest-yielding companies in the market standing at historically elevated valuations.
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
So, yes, when investors went looking for high dividend yields in the past, they did tend to find businesses that were cheap on all the metrics we mentioned above. As the current environment of ultra-low interest rates has pushed income-seekers to take yield wherever they can find it, however, the evidence now suggests looking for a stock purely on the basis of a high dividend yield will lead you to a stock of average to high valuation.
Of course, as we have pointed out in articles such as Inflexible friend, it is not impossible for companies to manipulate earnings numbers and this is something we are well aware of when we are valuing a business. But it is much easier to manipulate dividend numbers, which is why we are very wary whenever we see anybody – whether it is a company or the media – touting an investment on the basis of dividend yield alone.
Investors really do need to be digging deeper to ensure they are satisfied with the quality of the dividend-payer’s balance sheet and the sustainability of the cashflows generating that yield – and this has arguably never been more important than in the current environment when the market’s fixation on income has led to a significant expansion in the multiples of bond-proxy stocks.
To underline the point, let’s take a look at another chart from Empirical, which this time considers the pay-out ratios – that is, the proportion of earnings businesses distribute as dividends – by sector. As you can see, the pay-out ratios of healthcare and consumer staples companies – very much the sort of bond proxy stocks currently so popular with income investors – are at, or very close to, 30-year highs.
Developed markets (ex-U.S.) pay-out ratios by sector (1)
Source: Corporate Reports, Empirical Research Partners Analysis, data shown from January 1987 to September 2016. 1Capitalisation-weighted data
Taken together, we would hope these two charts would be enough to convince anyone to look beyond yield alone when they are considering any income-generating investment. Halloween or not, what could happen if – when – these businesses are no longer able to sustain their dividend pay-outs, or to maintain their elevated valuations, is a truly terrifying thought.