Dividend-paying stocks have been a favorite of investors since the 2008 global financial crisis. These stocks often provide predictable cash flow streams, low stock price volatility, and high yields relative to fixed income assets in the current low interest rate environment.
A focus on dividends has also proven to be an attractive long-term approach. Over time, dividends from developed market equities have made up a significant portion of overall investor returns. Unlike bond coupons, dividends tend to grow over time, which enables investors to reinvest a growing cash flow stream back into the underlying equities and help compound wealth.
Given the ongoing popularity of dividend stocks, we’ve been asked a number of questions about them, including:
- How much of this allocation to dividend stocks is the result of a recent fad?
- What are the underlying factors behind the popularity of these dividend-paying companies?
- Do the fundamentals of dividend stocks warrant current valuations?
We call these the three “Fs” of dividend investing.
While an emphasis on dividends has proven to be a consistent performer over time, recently there has been an increased focus on the style. In just the past five years, investors have poured more than $50 billion into Dividend Exchange Traded Funds (ETFs) (Exhibit 1).
So far in 2016, this focus on dividends has paid off for investors. The median dividend yield in the S&P 500 Index is currently 1.9%, and the median stock in the S&P has returned just over 11% this year. However, as yields go up, returns do as well. The median shareholder return for the top 50%, 25%, and 10% of dividend yields in the index have provided increasingly higher returns this year (Exhibit 2).
One of the most common pitfalls dividend investors encounter is unintended exposure to particular themes, commonly known as risk factors. Typical risk factors include currency risk, interest rate risk, growth vs. value, etc. Recently, we have seen significant growth in ETFs that are meant to provide exposure to these factors.
Among the beneficiaries of this growth are so called “low-vol” funds designed to own those stocks that are less volatile than the overall equity market. The chart below shows the growth of low volatility ETFs, from 0 in 2011 to over $35 billion today (Exhibit 3).
What are the largest components of funds like these? The top holdings tend to be concentrated in the sectors most associated with dividend-paying stocks: Utilities, Consumer Staples, Real Estate Investment Trusts (REITs), and Health Care.
The popularity of dividend strategies and factor ETFs that focus on low volatility has led to extreme valuations in many dividend-paying stocks. The current valuation is particularly stark when looking at defensive sectors only (Utilities, Telecom, REITs, Health Care and Consumer Staples). As a group these companies are now trading at an all-time high EV/EBITDA (i.e., a company’s Enterprise Value divided by its Earnings Before Interest, Tax, Depreciation, and Amortization) and close to peak Price/Earnings multiples (Exhibit 4).
For a more detailed analysis of the unintended factor exposures of low-vol strategies, see our recent blog, Low Volatility Strategies Now Behave Like Momentum Plays.
Despite the current Fad, and notwithstanding unintended Factor exposures driving valuations, the Fundamentals of dividend investing have been, and will likely continue to be, attractive. Consider the following chart showing total aggregate dividends paid by U.S. firms (Exhibit 5).
Despite a falloff immediately following the 2008 financial crisis, which was primarily driven by sizable reductions in dividends paid by financial companies, the long-term trend of dividend growth remains intact. Indeed, over the past 40 years total dividends have grown by an average of more than 7.5% per year.
Putting It All Together
It is clear that dividend investing has gained popularity since the financial crisis. This fad has driven sizable asset flows into dividend strategies, and has also benefitted from exposure to a related factor, low volatility. We believe the attractive fundamentals of dividends and dividend growth over time will continue. We are concerned, however, with current valuations, as the most widely held dividend stocks become over-owned simply as a result of flows into single-factor ETF strategies.
The good news for an active investor is that there is still value to be found among dividend-paying stocks. Our approach is to let dividend yields show us where the value may be found; in other words, yield as an indicator of value. To illustrate this, we compare the yields of defensive dividend-paying stocks with those of cyclical dividend-paying stocks (Exhibit 6).
Over time, defensive sectors have generally provided higher dividend yields than cyclical sectors; but most recently there is very little difference between the two. In other words, cyclical stocks currently look relatively cheap. We currently see attractive valuations in many cyclical stocks, including the following examples:
- Siemens AG: Siemens is an industrial conglomerate based in Germany. Its myriad business segments provide products for various industries such as power and gas, renewable energy, electrical equipment, building products, and automation technology. The company’s strategic plan, dubbed “Vision 2020,” is focused on improving underperforming segments, cost reduction, and prudent capital allocation. Results have been impressive so far.
- Eaton Corporation: Eaton is an electrical equipment company that has had a turbulent ride over the last few years due to choppy industrial end markets, a slower-than-hoped-for integration with Cooper Industries (the largest acquisition Eaton has ever made), and a slothful focus on cost controls across their platforms. With the integration of Cooper largely complete, and with a new CEO at the helm, restructuring across Eaton’s core business verticals is well under way. In our view, the current valuation offers both attractive capital appreciation potential as well as continued growth in dividends.
We believe the growing popularity of dividend investing is warranted, as dividend-paying stocks historically have generated attractive risk-adjusted returns. However, the explosive growth in single-factor strategies such as dividend and low volatility ETFs has led to “crowding,” i.e., over-ownership, among the most popular dividend-paying sectors.
As active dividend investors we see an opportunity to focus on those companies that have been neglected by this trend.
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1. As of 8/31/16, 1.75% of Oppenheimer Dividend Opportunity Fund’s holdings were in Eaton Corp.; and 1.71% in Siemens AG. Fund holdings are dollar-weighted based on assets and are subject to change.
2. As of 8/31/16, 2.3% of Oppenheimer Value Fund’s holdings were in Eaton Corp. Fund holdings are dollar-weighted based on assets and are subject to change.
3. As of 8/31/16, 1.59% of Oppenheimer Mid Cap Value Fund’s holdings were in Eaton Corp. Fund holdings are dollar-weighted based on assets and are subject to change.
It should not be assumed that an investment in the securities identified above was or will be profitable and do not constitute recommendations by OppenheimerFunds.
The S&P 500 Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy. The index is unmanaged, includes reinvestment of dividends but does not include fees, expenses, or taxes, and cannot be purchased directly by investors.
There is no guarantee that the issuers of stocks will declare dividends in the future, or that dividends will remain at their current levels or increase over time. Value investing involves the risk that undervalued securities may not appreciate as anticipated. Mid-sized company stock is typically more volatile than that of larger company stock. It may take a substantial period of time to realize a gain on an investment in a mid-sized company, if any gain is realized at all. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile.
Value investing involves the risk that undervalued securities may not appreciate as anticipated. Small-sized company stock is typically more volatile than that of larger company stock. It may take a substantial period of time to realize a gain on an investment in a small-sized company, if any gain is realized at all. Diversification does not guarantee profit or protect against loss.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.