Switch high-dividend payers for value stocks?

One of the hottest trades for investors over the last two years has been buying large companies that pay high dividends. With a continued weak global economy and near-zero interest rates, investors have turned to “blue-chip” companies that they know and that pay dividends significantly higher than they can get on a bond or bank deposit.

They have turned high-paying dividend stocks into bonds, and that can’t be good. People forget that even though a stock pays a 4 percent to 6% dividend, it doesn’t mean that it can’t lose 40%-50% of its principal value. We have seen it happen time after time.

The media is full of headlines such as “5 dividend stocks for a successful retirement” or “Retirement strategy: Buy any dips in dividend winning stocks.” It’s as if there is no need to plan for retirement, to analyze goals or needs – just invest in dividend stocks and you are good to go. It’s the panacea for retirement.

Just to be clear, I am not at all against dividend stocks. It’s just that when investors start substituting stocks for bonds and deposits, I get nervous. It seems to me that the valuation on many if these stocks is very rich. A basic rule in investing: Nothing goes up in a straight line forever.

Am I wrong?

Well Kevin Mahn, president and CIO of Hennion and Walsh Asset Management, thinks so. In an interview with Forbes, when asked whether he thought dividend stocks were in bubble territory, he said: “Yeah, I think what we’re finding now is any time that we see an asset class or a sector that’s run up in value, people tend to believe that it’s the next bubble. And I think bubble may have been an appropriate term for the mortgages in the subprime market. But trying to extend that analogy to gold or to dividend-paying stocks is a stretch from my perspective.

“Let’s just look at dividend-paying stocks and how they perform going all the way back to 1972. What you can see is that in bull markets or bear markets, dividend-paying stocks actually provide a great deal of value in all type of market environments. Consider that close to 50% of a stock’s total return historically comes from its dividend.”

I agree that not just because something increases it becomes a bubble. But when historic data shows that things have gotten out of proportion, it pays to pay attention.

Let’s look at the data

While funds continue to flow into high-dividend payers, data indicates that these stocks could be in for hard times ahead. Some analysts are actually starting to sound the alarm on this dividend trade and are encouraging investors to make a move into value stocks.

Vadim Zlotnikov, chief market strategist at Alliance Bernstein writes: “We see significant opportunity for outsize returns in deep-value stocks and an unusually high degree of downside risk in the high-dividend payers. You can see the opportunity by comparing the weight of the two groups within the S&P 500.

“Outperformance by stocks paying high dividends has driven their index weight to a record high: Almost 45% of the index’s market capitalization is in stocks with a dividend yield 20% or more higher than the index... At the same time, underperformance has driven down the weight of low-price-to-book stocks. Roughly 25% of the S&P 500’s market cap lies in stocks with a price/book ratio 20% or more below the market P/B. That’s even less than during the tech bubble!” That sounds like a bubble to me. If we see some economic improvement, institutional investors could bail out of dividend stocks in favor of the historically cheap value stocks. If this happens, do-it-yourself investors should be prepared and not be left holding the bag, as these stocks could drop.

Zlotnikov adds: “If we assume a relatively conservative 10% future outperformance by low-price/book and 10% underperformance by high-dividend paying stocks, index investors may be leaving almost 200 basis points annually on the table, owing to the biased construction of the S&P 500 today. And we estimate that a portfolio with exposures to high-yield and deep-value stocks close to the historical average could outperform the S&P 500 by as much as 15%.”

Not bad.

Contact your financial adviser to see if you may be overexposed to dividend stocks and if a transition to value makes sense.

aaron@lighthousecapital.co.il Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts.