Concerns that income-generating assets are looking expensive are by no means restricted to the fixed income sector. Since dividends are in themselves a form of valuation metric, it may feel like something of an oxymoron to suggest high-yield stocks could be expensive and yet, at least in some parts of the world, that now appears to be the case.
In reality, there is no reason why a stock with a high dividend yield cannot be expensive on other metrics. The decision to pay a dividend is of course discretionary so management could in theory distribute all of a company’s profits rather than reinvest any in the business, thereby increasing its yield artificially and, in all likelihood, temporarily.
We can see that on average high-dividend stocks have tended to be rated more cheaply than the broader market. As the three charts below illustrate, the top 20% of the highest-yielding stocks in Europe, the US and Asia have each historically traded at a notable discount to the rest of the market – back in 1988, for example, the respective price/earnings (P/E) ratios in both the US and Asia were about 10x and 15x.
Past performance is not a guide to future performance and may not be repeated.
There are two main reasons that high-dividend yield stocks tend to trade on a lower P/E:
- They could be well-liked businesses where management are electing to distribute a large fraction of earnings as dividends. by distributing more, and reinvesting less, future profit growth will be reduced, justifying a lower P/E rating but increasing the yield;
- Alternatively, they could be unloved-businesses where the market does not believe in the future prospects of the business, and is paying a low multiple for both earnings and dividends, implying a lower P/E rating and a high yield.
As the technology bubble inflated in the late 1990s – with people far more interested in owning new dotcom businesses than, say, utilities or supermarkets – this discount widened significantly and, once the bubble burst, it narrowed once again to its long-term average of roughly 30%. but then something changed – at least in the US.
This century, the discount between the top-yielding stocks and the rest of the market has remained fairly consistent in Europe and Asia. However, what you can see in chart 2 above is that since 2004, when a big cut in interest rates led us investors to seek out income-generating assets, high-dividend stock prices have been bid up to the extent they now trade on the same P/E as the broader market.
Regular visitors to The Value Perspective will know that any sort of historical high or low generally makes us nervous. If the highest-dividend-yield stocks in the US also have high P/E ratios, that suggests that investors are paying more for businesses just because they are distributing more of their profits, despite the fact that this will reduce future growth. We would question the long-term benefits of these investments.
Investors should also be thinking about what could happen when, at some point in the future, interest rates do return to their longer-term averages. looking at the 25 years of history in the three charts above, it seems reasonable to believe high-dividend stocks will mean-revert to a similar level of discount to which they have always traded.
As we discussed earlier, there is a good reason why high-dividend stocks have on average traded at a discount to the wider market. as such, either the world has changed, and investors can now have their cake and eat it (income today plus market-equalling earnings growth tomorrow) or else they are paying more than they should be. Here on The Value Perspective, we would argue the US is now a dangerous place to go fishing for high-dividend stocks.