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For a while, dividend investing paid dividends like never before. And then, five months ago, it stopped. There are ways for investors to take advantage, but they are counter-intuitive.
In the post-Lehman years, investors put more weight than ever on the dividend yield they received from equities. In some ways, this was irrational. Under the Miller and Modigliani framework, still taught in business schools, they should have known that dividend yield makes no difference. Cash belongs to the investor whether it stays in the company’s bank account or is paid out in a cheque. If you need income, you can just sell some shares. For many decades, investors took M&M seriously, and yields dwindled.
Putting weight on dividends was a symptom of acute lack of trust. It is the ultimate “show me the money” investing. It also showed desperation for yield from any source, when interest rates were held artificially low. Since the S&P 500’s pre-crisis peak in 2007, high-yield bonds have comfortably outperformed stocks.
But high-yield bonds generally come from low-quality, or “junk”, companies. As a safer option, many turned to “quality income” in the stock market. Société Générale has produced its own global quality income index, which includes “quality” stocks (with strong balance sheets and consistent earnings) that also pay a good dividend yield. These are not exciting companies. The 71 defiantly boring index members presently boast a dividend yield of 5.22 per cent, roughly double the average yield for developed world indices, which is about 2.5 per cent.
Buying such stocks is a strategy to avert disaster. They will hold their value even when the market as a whole is selling off, albeit they do not join in with rallies to the full. But in the past few years, the index drastically outperformed in a rising market. Starting at the top of the market in October 2007, it had beaten the MSCI World index by some 27 percentage points by May this year. Then “taper talk” started, bond yields rose, and everything went into reverse.
Since then, SG’s quality income index is down 2.7 per cent, and has lagged behind its benchmark by 4.3 per cent. The market has specifically sold off high-yield stocks.
Normally, a high dividend yield is one of several factors that value investors, who buy stocks when they are cheap, look for. Value stocks have prospered since taper talk started. But dividend stocks have been punished. According to Style Research, a London-based group that breaks down how different factors contribute to stock performance, a high yield alone caused a US company to underperform by 1.4 percentage points in the months from June to August, when taper talk was at its height. Returns to other value factors, such as a low price-to-book ratio, were positive.
Since Lehman in 2008, growth stocks – chosen because their earnings are growing rather than because they look cheap – have comfortably outperformed value stocks. But quality income beat both, even though it would normally be regarded as a kind of value investing.
Soc Gen’s Andrew Lapthorne, the inventor of the index, says it was the period of outperformance post-Lehman, rather than the sell-off once taper talk started, that was exceptional. As a disciplined conservative long-term style of investing, it still makes ample sense, shielding investors from big falls, while accruing growth each year thanks to dividends.
But Europe has a different picture. The European version of SocGen’s quality income index is still slightly ahead of the FTSE-Eurofirst 300 for the year, with a total return of 15.6 per cent. It has not fallen during taper talk, even though German Bund yields rose roughly as much as US yields.
This is unlikely to be because Europeans need income per se. Rather, it is because anyone investing in Europe is still biased towards security, and a company with a high dividend yield – with some financial security behind it – is seen as more trustworthy than another. Europe has rallied more than the US in recent weeks. But this is a “tell” that sentiment towards the continent remains angst-ridden.
Indeed, Absolute Strategy Research in London suggests that European quality stocks are in a bubble, with high-quality stocks registering double the performance of low-quality stocks since Lehman. Bubbles always eventually deflate.
This position may be extreme, but it does seem true that if Europe’s economy takes off – as many hope – then European income stocks are due a period of bad underperformance. Experience elsewhere suggests they could be punished for having a high yield as sentiment recovers.
Buying stocks with high, growing and well-protected dividends is almost always a good idea for the long term. But in the current weird circumstances, buying them in the hope that they can maintain the performance of the past five years for a year or two longer would be a bad idea.
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