Peters: No Dividend Bubble
Dividend-paying stocks are fairly valued, but low payout ratios indicate that there could be more room for dividend growth, says Morningstar DividendInvestor editor Josh Peters.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Morningstar DividendInvestor editor, Josh Peters, to see if there is a bubble in dividend-paying stocks.
Josh, thanks for talking with me today.
Josh Peters: Good to be here. Can't believe people are throwing the B-word around in my sandbox. This is really unusual.
Glaser: Yes. It's not an area of the market that we generally talk about. There's rampant speculation. But with a lot of investors looking for yield, there has been some talk that there is a bit of a bubble, that people are throwing money into anything with just a little bit of extra yield and maybe not thinking about valuation. What's your take on the general level of valuations of dividend stocks, right now?
Peters: I think, the word bubble really doesn't work well for dividend-paying stocks because if you go into the market, you're looking for a high yield. As the price goes up, the yield comes down, until the stock isn't even a high-yield stock anymore. So, people focusing on dividend yield, I think, is actually a good pressure-relief mechanism because as the price goes up, you're getting that lower yield. It's telling you that the stock is becoming less and less attractive as it goes along. For a bubble or this sort of vertical-type of price behavior, I'm not seeing that. Dividend-paying stocks, high-payout stocks, and high-yield stocks had good absolute returns and very good relative returns last year, but they didn't move into what we think of as overvalued territory as a whole.
That said, some areas of the high-yield market do look pretty expensive. REITs, I think, right now are quite expensive. Typically you would expect to see a REIT yielding at least 4% or 5% even in a low-interest-rate environment. Just throw to out one name, Public Storage, ticker symbol PSA, which operates of self-storage facilities, yields only 2.75%. It's overvalued enough to get a Morningstar Rating for stocks of 1 star relative to our fair value estimate. There's a case where I think that people's interest in yield, their interest in real estate, and their interest in defensive cash flows has really, really inflated the price of the stock beyond what we think it can support going forward.
Regulated utilities, especially the fully regulated firms that don't have any energy market or commodities exposure of any meaningful extent, also look pretty expensive. Piedmont Natural Gas actually was one of my favorite utilities from a fundamentals standpoint. I think it's very well run, it's got great regulatory relations, it's got a good geographic footprint, and it has a terrific record of dividend growth. But when I see a stock like that yielding only 3.5%, you're just not going to get the kind of growth that can make up for that kind of a yield and actually generate a good 9%-10% total return over time. And Piedmont is another stock that earns a 1-star rating. So, there are some areas where I think we're looking at some overvaluation. But on a whole, I would describe the high-yield universe as being fairly valued.
Glaser: Even if we're not seeing ridiculous valuations in high-yield stocks, do you think that there is a bubble, so to speak, in allocations? For example, investors who were previously focused on fixed income but are seeing very low yields in that sector are now moving into dividend stocks, but maybe they aren't totally aware of the risks that are inherent in owning those equities?
Peters: I think we have something of a supply and demand issue. I think there's more demand out there and more people who would like to own higher-yielding stocks and be getting those reliable steady cash dividends. They would like to not have as much emphasis on growth and not have to count so much on the uncertain capital gains, but there's only so much dividend income to go around. So, this has led those companies that do have relatively high payout ratios, the companies that are paying out 40%, 50%, or 60% of their earnings, such as REITs, utilities, and packaged-foods companies, to get up to valuations that are pretty fair or in some cases full. And some of the cases like I just mentioned, there's also the occasional stock that's quite overvalued.
What I think we really need to see is companies start to respond to this situation, and say, "Investors just don't really trust us to be able to grow the business at double digits. They don't trust the stock market to reflect the value of earnings that they're not getting through dividend checks." I really want to see the payout ratio in the stock market start to come up. Last year and in 2010, we had the lowest payout ratios for the S&P 500 on record at 29%-30%.
As earnings continue to grow, dividends need to grow a lot faster in order to start to close that gap. That payout ratio gap really explains why the stock market still yields only 2%. You go back a couple of decades, it was routine for the stock market to yield 4%; that's actually the long-run average over the last 100 years, even including the last decade and a half or so of very low dividend yields on stocks. Four percent is what you would get if companies actually paid out the normal historical payout ratio of a little over 50% of their earnings.
I'd like to think of this as a process that could actually be positive. To the extent that companies that do have good dividend yields and provide investors with a significant share of their earnings through cash dividends, if those companies are getting better valuations, then the companies that aren't providing the good dividends will likely get a signal from the marketplace that they need to step up their dividends and change their capital-allocation approaches. They need to de-emphasize share buybacks, certainly. They need to de-emphasize acquisitions, which many don't create value for shareholders anyway, and they really should take the pressure off of needing to grow so fast in order to justify themselves. Paying a dividend of 5% automatically takes down the growth rate people would expect you to achieve by 5 percentage points, maybe more.
Glaser: Josh, you mentioned some overvalued stocks. Do you have any dividend-paying stocks that you think look somewhat undervalued right now?
Peters: Well, that's one of the things that's making this environment kind of difficult. There are a lot of fairly valued stocks, and there are some overvalued stocks. But there really aren't a lot of bargains. There are not a lot of stocks that you can say, "I'm buying it for $0.80 on the $1, or $0.70 on the $1. I've got some protection in case I'm wrong in my estimates and things don't work out as well as I had hoped." Those cases are kind of rare.
One of the outliers I continue to point to is General Electric. Our fair value estimate for the stock is $25. We think that the industrials side of the business is going to continue to perform very well, and that's where management is really emphasizing growth, both internally and through acquisitions. They're reallocating capital from the financial-services operations to the industrials operations.
At the same time, for GE Capital Services, its balance sheet could not have turned around more dramatically in terms of its capital strength, its liquidity from where it was back in 2008 before the crash. That of course led GE to cut its dividend; that was very painful. I didn't see that dividend cut coming. I certainly wouldn't want to own a stock in advance of something like that. But I think investors still aren't giving GE enough credit for how fast they firm is bringing that dividend back. GE has raised the dividend now four times in the last two years. Even though the stock has come up a little bit in the last couple of months, it's still able to provide a yield in the mid-3% range. And I think that dividend continues to grow probably at a double-digit percent rate for another couple of years as it recovers, and the firm can maintain long-term dividend growth in the high single digits after that.
To me that's a really compelling total-return profile from a very high-quality company that investors just are still sour on. GE is having to reprove itself to the investment community after what's been a tough 10-12 years for shareholders. But the firm is doing it the right way. It's doing it with dividend increases and with the Back to Basics movement, emphasizing the industrial businesses, which are really GE's historic strength. So, that's one name that I continue to think provides investors with a very good opportunity to get a good yield, get a good total return, and get something with a margin of safety.
Glaser: Well, Josh, I really appreciate your time today.
Peters: Thanks, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.
Jeremy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.