US dividend play at risk of overrunning

June 5, 2013 9:30 am

US dividend play at risk of overrunning

By Michael Mackenzie in New York

Some investment trends are like a long-running Broadway or West End show. No matter how stale the storyline, an infusion of new cast members can attract renewed interest from audiences.

When it comes to buying stocks, owning high dividend paying companies has been the trend to follow for some years. But, with the US equity bull market in its fifth year and the S&P 500 occupying record territory, the preference for owning stocks that pay hefty dividends is under assault.

High yielding stocks in the utilities and telecoms sectors have fallen sharply over the past month, thanks to the sharp jump in bond yields that has reduced the attractiveness of such companies. The pressure on these traditional high dividend paying sectors is the first sign that their high valuations have finally became too lofty for investors seeking income.While this is a shot across the bow for the dividend investment theme, investors have spotted opportunities outside the traditional areas of the stock market that have long been a source of income for shareholders.

With S&P 500 companies sitting on more than $1tn of cash and reaping record profits, their argument is that the dividend trade can expand further as pressure intensifies on executives to return excess cash to shareholders in the form of a higher payout ratio.

Diane Jaffee, portfolio manager at TCW, says the current S&P 500 payout ratio is below the average of 40 per cent for the past 20 years and 52 per cent for the past 80 years.

Stockpiling cash may appeal to company managers and is certainly prudent given the uncertain outlook for the global economy. But increased shareholder activism has already forced some notable about-turns, with Apple being the most prominent example. Others are expected to follow Apple’s lead.

“Shareholder activists are kicking and screaming, Apple is a good example of this,” says Ms Jaffee. “There is some realisation in the technology sector that companies are coming of age and are cash rich.”

James Morrow, portfolio manager at Fidelity Investments, says: “Companies have to remember the ‘share’ in shareholder.” He estimates that were the stock market to revert to its usual payout ratio then the S&P dividend yield would rise to about 3.25 per cent.

Moreover, the rise in the number of retiring babyboomers – and their demand for income – could also tip the scales away from companies issuing share buybacks towards those paying higher dividends.

“It’s possible we could see companies switch from buybacks to issuing dividends,” says Vadim Zlotnikov, chief market strategist at AllianceBernstein. “The pressure on management to do so will grow. You get more credit from shareholders for doing a dividend than a buyback.”

The focus of investors, then, should be on companies that are cashed up and are either increasing their dividends or will soon move away from buybacks and reward shareholders with a payout. Investors are paying attention. So far this year Vanguard’s Dividend Appreciation exchange traded fund (ETF), which tracks companies with a history of increasing their dividends, has seen inflows of $2.2bn, just shy of 2012’s total inflow of $2.21bn, according to Index Universe.

“I’m a strong proponent of dividend growth over dividend yield,” says Mr Zlotnikov. He says companies with high free cash flow yield and a low payout relative to their peers, as found in the technology, medical technology and integrated oil sectors, look appealing.

Analysts at Goldman Sachs expect dividends will rise 30 per cent between 2013 and 2015: “The current and potentially sustained low-yield environment is a compelling reason to own companies with both attractive dividend yield and dividend growth prospects.”

Mr Morrow says technology, healthcare and financials have the most capacity to increase their payouts to shareholders, although the ability of banks to boost their dividends is subject to approval from the Federal Reserve.

Among the financials, Ms Jaffee says Citi looms as the most exciting name as its current payout ratio is 0.1 per cent. She adds Intel and Cisco, with dividend yields of 3.7 per cent and 2.8 per cent respectively, as two examples of companies that are also investing heavily in research and development.

Yet, while the dividend trade flourishes in a climate of fragile economic growth, its adoption by companies also conveys the sense that management sees less opportunity for investing in future growth. That casts a shadow over the long-term prospects for stocks.

“Higher dividends are an underlying signal of companies reluctant or unwilling to invest for the future and over time investment is what drives multiple expansion,” says Nicholas Colas, chief market strategist at ConvergEx Group. At some point, even the most successful of long-running shows dim the lights.