As Sam Sees It: Digging Deeper into Dividend Stocks

Sam Stovall  |

Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.

EQ: As you’ve pointed out before, the hot streak that stocks have enjoyed in the past five months have been led by the defensive sectors, primarily because of their ability to pay better dividends. Why have investors put such a premium on dividend stocks when the market has been so bullish?

Stovall: What’s interesting is that you could say that the market has done so well because of the defensive stocks. The first quarter of 2013 saw the S&P 500 rise 10 percent. Without knowing the backdrop, investors probably would’ve thought it was led by the cyclical sectors, only to be surprised that it was, in fact, led by the defensive areas of Consumer Staples, Health Care, and Utilities. The reason behind this defensive leaning is two folds.


First, investors are reluctantly coming back into the stock market, but they realize that they’re getting in late so they’re gravitating more toward the low volatility groups in case the market does go through a digestion on recent gains, these low beta groups will likely fall less than the more cyclical sectors.

Second, the Federal Reserve really has encouraged investors to gravitate toward the higher-yielding groups because investors basically are sounding like Richard Gere from the movie An Officer and a Gentleman when he wailed, “I got nowhere else to go!.”

So investors are focusing on those stocks that end up yielding what they used to get in bonds. Also, I think there are some investors are worried that we are headed back to a global economic slowdown, and as a result, they are gravitating toward the defensive areas because the demand for these products and services remain fairly static. In other words, the demand does not necessarily change whether we are in an economic expansion or contraction.

EQ: Are dividend stocks as a whole currently overbought?

Stovall: I think certainly the dividend sectors do look a bit expensive. Right now, they are trading at 17 times projected 2013 estimates, versus 14 times for the S&P 500, and 13.5 times for the cyclical sectors. So the defensive sectors certainly are trading at a premium to the market and to their more cyclical peers.

At the same time, what I looked at is whether the stocks are overbought not only from a valuations perspective, but also how high they are as compared with their 40-week (200-day) moving average. Right now, the defensive sectors are 10 percent above their 40-week moving average. Since 1994, the normal average is 2 percent, which translates to an 8 percentage point spread. The cyclical sectors are only 4 percent above their 40-week moving average, and normally, they’re at 3 percent. So that translates to only a 1 percentage point premium above their more normal 40 week moving average.

EQ: The average dividend yield for the S&P 500 is sitting pretty close to historic lows, and has been trending lower for the most part for decades. What are some of the causes for this trend, and do you see it reversing at any point?

Stovall: The reason we’ve been seeing lower yields on average could maybe be out of a fear of commitment. But what we’re finding is that the further we get away from the 1930s, the less investors feel they need to be paid to be attracted into the stock market. Back in the 1940s, the average dividend yield for the decade was 5.7 percent. In the 1950s, it was 4.8 percent, and then basically we worked our way down to 2.4 percent in the 1990s, and for the first decade of this millennium, we were at 1.8 percent. We’re a little higher at 2.2 percent right now, but that’s still very low. I think corporate management needs to feel confident enough in the direction of the economy, and also get a better read on how the changes on the tax laws may affect their decision to increase dividend rates before they decide to do because once you do, you pretty much have to stick with it.

Also, the average payout ratio going back to the 1930s was 52 percent. In the 1940s, it was 60 percent, and then has gradually come down until now, where it sits at 43 percent. So we still have 9 percentage points to go just to get back to the long-term average. Again, it shows that there is room to move higher. It just depends on whether corporate management will be willing to make that commitment.

EQ; As you noted in this week’s Sector Watch report, there are an overwhelming number of companies paying dividends, and most of the high yielders are in the small and mid-cap space. For investors attracted to high dividend payers, what are the risks of chasing yields?

Stovall: I like to tell investors, “Don’t yield to temptation.” What I mean is, don’t buy a stock just simply because it has a high yield. It probably has a high yield for a reason, meaning that the market probably has already sold out of this stock in anticipation of a dividend cut. So, in a sense, they have sold to the “dumb money” or the investors who are not willing to do the research. As a result, you might own the stock just shortly before company management announces a cut in the dividend rate, and that would cause the price to tank. Also, I think you could end up buying a stocks that has a relatively high yield, but at the same time, it could also have relatively high valuations like their P/E ratios, which would mean that the company is trading higher than where it should be.

You need to look to a variety of things. Investors need to look to the past, present, and future to make wise yield-oriented investment decisions. When I say look to the past, I mean look to the S&P earnings and dividend quality rank, which is a letter grade of A-, A, or A+. All three of which indicate that the company has increased its earnings and dividend at an above-average rate in each of the past 10 years.

Look to the present means go for dividend yields of 3 percent or more. You don’t need to start at 5 percent. Based on today’s low inflationary environment, you’d be well-served to start the cut-off at about 3 percent.

Look to the future means to look for companies that have favorable investment recommendations because an analyst is not typically going to say buy if they believe the dividend will be cut.

EQ: It seems a bit surprising that there are so many small and mid cap stocks paying dividends. Isn’t it counterintuitive in that they would probably want to reinvest the capital back into growing the business?

Stovall: Well, you would think so. However, a lot of real estate investment trusts are going to be in the mid and small cap area, and by law, they have to return something like 90 percent of their profits to investors. So you’re going to get a pretty high payout.

Also, there are companies that you could maybe call “the large-cap stocks that never were” because they didn’t grow enough. For example, a one-product company that doesn’t have enough of a market to become a large cap, may have also resisted all attempts to be bought out because they are a cash cow and have chosen to return a lot of the money to shareholders through a higher-than-average yield in lieu of upward price potential.

EQ: You also identified some quality dividend paying stocks and ETFs that investors may want to look at. Do dividend ETFs function the same as dividend stocks from a strategic investment perspective?

Stovall: They do because ETFs are simply the package in which the stocks are found. If you buy a basket of stocks on your own, then in a sense, you are an ETF. An ETF simply owns a basket of stocks that the originator decided to put into the fund. S&P’s MarketScope Advisor research service has an ETF evaluator that actually looks at the underlying holdings within the vehicle to come up with investment recommendations that are forward-looking. So it really is important to know what’s in the ETF because that will decide whether the ETF goes up or down in price.

Stock price data is provided by IEX Cloud on a 15-minute delayed basis. Chart price data is provided by TradingView on a 15-minute delayed basis.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:

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