Numbers of dividend-yielding equities are seeing price appreciation over and above the market. This means that dividend-yielding stocks–which “normally” trail behind growth stocks in price appreciation over a certain amount of time–are actually going up in value more than growth stocks. The iShares Large-cap Growth ETF (IVW) is up less than WisdomTree’s large-cap dividend ETF (DLN)–6.06% vs. 6.64%, although the latter also has a (variable) dividend yield of about 3.4%. This trend is clear on a sector-by-sector basis; dividend-yielding telecommunication and consumer staple stocks are going up faster than the higher risk but theoretically higher rewarding small-cap stocks. While Vanguard’s small-cap ETF (VB) is up 8% YTD, AT&T is up 7.33%, and it offers a near 5% dividend yield on top of that–much better than VB’s 1.72%.
These comparisons point to one unsurprising trend: large-cap dividend yielding stocks are again a favorite of investors, and market demand is raising their prices. This is exactly what we saw at the beginning of 2012, and is most likely to be a common story for 2013 until a sudden unsuspected calamity hits the markets and causes prices overall to fall.
The Flight to Safety
The bull run of dividend-yielding large-cap stocks is paradoxically not a sign of confidence; it’s a sign of fear. While a lot of mainstream outlets might tote the S&P 500’s rise and the Dow Jones’s 14,000 milestone as signs of recovery, they are signs that investors are looking for a safe but profitable investment.
There are three types of stocks: large-cap, mid-cap, and small-cap. Historically, the larger capitalization stocks have lower risk and lower rewards, with small-cap stocks representing the greatest growth. Aggressive investors who are feeling optimistic about the economy will move into small-cap stocks, because the potential of growth impacting those small-caps favorably tips the risk/reward profile into “buy” territory. Small-cap purchases are a good indicator of market optimism. Movements away from small-caps and towards large-caps are a sign of a trend toward safety in the market, because the risk/reward ratio of these investments is too heavily weighted towards risk.
The Flight to Capital
Large-cap purchases are a bit more complicated, especially when dividends are taken into account. Yes, buying shares in AT&T is a sign of faith that AT&T will keep making profits, which is only possible if people keep using telephones. The same goes for buying Intel (INTC), Coca-Cola (KO), or McDonald’s stock. But it can also be a sign that these are fundamentally safer positive-yielding investments than most other options out there.
In previous economic downturns, the flight to safety was an outflow from equities to bonds; investors saw risk in investing in stocks, so they went to U.S. and municipal bonds. These days, such a move is not too appealing. U.S. bonds are yielding below 3%, and municipal bonds aren’t yielding much more. Plus, the price of municipal bonds have gone up and up in what some consider to be a bond bubble waiting to pop. Bonds just don’t look good now.
The other option, of course, is money market accounts, CDs, or just plain savings accounts. But who wants to earn less than 1%, even in this time of low inflation? No thanks.
So what else is there? Corporate bonds (PHK, VCSH, VCLT) are an option, but their rates are hardly over 6-7% unless you go into junk bond territory with high default rate risk. With equities dipping on various frightening headline events–the fiscal cliff, the U.S. credit downgrade, China’s slowdown, Eurozone disintegration, oversaturated emerging markets–there are tremendous buy opportunities for dividend yielders. In 2011 and 2012, it was easy to get T and VZ at over 5% yield levels. Why not pick up a few shares and enjoy high yields now, with higher yields to come with increased dividend payouts around the corner?
Investors recognize that corporate profits are high amidst years of cost-cutting. Governments are having financial woes and individuals have less spending power, but companies are doing very well. So why not buy equity in those companies and enjoy their competitive advantage in the investment marketplace?
The Value Investor’s Dilemma
The attractiveness of dividend-yielding stocks in recent years is an anomaly when we look at recent history. In the late 90s, dividends were a fool’s game; the real action was in tech growth stocks. We all know what happened there.
Value investors like Warren Buffett thrive in investing consistently against the trends by looking solely at their accounting metrics. When people build bubbles in housing or tech stocks, value investors keep buying well-valued dividend-yielding companies that hold the promise of growing their businesses in the future. The late 90s were a great time to buy unsexy stocks like MCD and KO. McDonald’s now offers a 12.3% yield-on-cost for investors who bought into the name in 1997.
So the market’s move towards dividend-yielding large-caps is an affirmation of the wisdom of untrendy, consistent value investing. While that may be good for the value investor’s ego, it’s bad for business: with so many people buying into dividend yielding stocks, their current yield-on-cost levels have fallen low. Thus the value investor’s dilemma is to decide whether to buy at recent high levels or wait for another crisis to offer great entry points.
Each investor needs to decide this question for themselves on a case-by-case basis. But in Buffett’s recent annual letter, he affirmed that the “risks of being out of the game are huge compared to the risks of being in it.” Even if an entry point today isn’t as good as it was yesterday, waiting to buy until tomorrow is even worse. Buffett’s answer to the dilemma is that there is none. Other value investors might see things differently–especially if they buy now, only to see the next crisis make their portfolio’s net liquidation value plummet.