Dividend investing seems to be all the rage at the moment. What with interest rates below inflation and bond prices dangerously high, it seems like everyone is suddenly a dividend investor. Usually when an investment strategy becomes popular it’s time for smart investors to look for the exit. So should dividend investors move onto something else?
Two types of dividend investing strategies
There are two broad strategies which come under the dividend investing umbrella.
The first is the trusty old high yield strategy.
With this strategy the first consideration, and sometimes the only consideration, is the current yield on offer. If the yield is “high” – however that is defined – then the shares are a potential purchase. On the other hand, if the yield is “low”, then the shares will not be bought, no matter what the growth prospects of the dividend may be.
The second strategy is the dividend growth strategy.
The aim here is to focus on dividend paying shares, but to put more weight on the ability of the company to grow the dividend in the long-term, rather than just on the current yield. Some dividend growth investors will even buy if the current yield is below the market average.
High yield investing is never really popular
High yield investing is almost always a contrarian strategy to some degree, and that means it’s almost never truly popular.
The logic is simple.
When shares are popular their price is pushed up by demand from investors. When share prices go up, dividend yields go down. Therefore, if a share is truly popular it almost never has a higher than average yield.
That’s why high yield investors never have to worry (much) about stock market bubbles.
However, there is a caveat. If you’re a high yield buy-and-hold-forever investor then you do still have to worry about bubbles and the excessive popularity of any shares you hold.
If you buy a high yielding stock and sit on it for 10 years, then there is a good chance that at some point those shares will become popular. This will drive the share price up and the dividend yield down.
Your original high yield share may end up in a speculative bubble and if you’re excited by the gains then you may be desolated by any subsequent losses when the bubble ends.
One way to avoid this is to keep an eye on the yields from your shares (both dividend and earnings yields), and if they move below average then perhaps it’s time to re-evaluate that investment in case it has become overpriced.
Dividend growth is where the danger lies
Dividend growth investing is the current favourite, and that’s not exactly a surprise. Low and negative bond yields are pushing investors into riskier assets, and a relatively safe first step into equities from bonds is to stick with blue chips.
Many solid, high quality blue chip stocks trade at a premium to the market, and that’s entirely reasonable as they can generate high rates of growth, more consistently than the average company.
But how much of a premium is too much? Is the current dividend growth premium too high?
One of the metrics included in the UK Value Investor Stock Screen is Growth Quality. This measures how consistently a company has produced a growing stream of profits and dividends. Blue chip companies tend to have an above average Growth Quality score.
So what do current valuations tell us about the popularity of dividend growth investing, and whether it’s time to get out or stick with this strategy?
|Growth Quality Score||Average Growth Rate||Average Dividend Yield||Average PE Ratio|
|90% to 100%||15.6%||2.6%||21.6|
|80% to 90%||11.6%||3.0%||17.3|
|70% to 80%||6.0%||3.4%||16.0|
|60% to 70%||-0.7%||3.9%||18.7|
The table shows the results from FTSE All-Share companies with a decade of unbroken dividend payments. They’re shown in order from the most consistently growing companies (high growth quality) down to those that have little growth and/or little consistency (low growth quality).
The first thing to note is that, as you’d expect, growth rates are highest for those companies that grow consistently. On the other hand, companies that have little consistent growth have a negative growth rate on average, which of course isn’t brilliant for a dividend growth strategy.
Looking at valuations, let’s take the dividend yield as this is an obvious valuation metric for dividend investors. You can see that investors are accepting a lower yield (i.e. paying a higher price) for companies that can generate high quality growth. Again, I think that’s entirely reasonable and to be expected.
The question is whether or not that premium is excessive.
Looking further down the quality range it seems that yields grow as quality falls. Again, that’s what I would expect. Investors are less sure of getting higher dividend payments in future from low quality companies, and so they demand a higher dividend payment today in the form of a higher dividend yield.
Does there appear to be a spike in the valuation of high quality companies? I don’t think there is. The difference in yield between each range of stocks is 0.4% to 0.5% in each case. Investors are generally paying more for higher quality stocks, but I don’t think they are overpaying for quality just yet.
What about PE ratios? Although I’m not a fan of PE ratios they can still be useful when looked at as an average across many stocks, which is what we have here.
You can see that shares of the highest quality companies have the highest PE ratios, and again the pattern is decreasing PE ratios as the quality of the companies goes down.
There is a bit of an anomaly in that the lowest quality companies have relatively high PE ratios on average. I expect that’s because these companies have quite choppy earnings and so in any given year their PE ratios may be quite high simply because the earnings in that year are particularly low. In that case the dividend yield may, on average, be a better valuation metric.
In any case the average PE ratio of the highest quality companies (21.6) is about 25% higher than those of the next group of stocks (PE of 17.3), and those in turn are 8% higher than for even lower quality companies (PE of 16).
I don’t think dividend investors should switch to another strategy just yet. High yield investing is almost never truly popular, and there is scant evidence that most dividend growth stocks are overvalued.
However, that doesn’t mean that some individual dividend growth stocks aren’t overvalued. I know of several high quality blue chip stocks which I would say are very overvalued, precisely because they are seen as bastions of safety. But while those companies may be safe, their share prices are not.
One way to avoid overpaying for high quality, dividend paying companies is to always keep a close eye on valuations.
If the dividend yield is far below the market average, and the PE ratio far higher, then no matter what the quality of the company, or how well it performs in the years ahead, your investment returns may prove to be deeply disappointing.
If however, you stick to high quality companies at relatively low valuations, your investment returns may pleasantly surprise you.