The financial media love bubbles. They’ve called seven of the last two. Gold was a bubble at $1,000 (U.S.) and again at $1,500. At today’s price, it’s a bubble with a capital B. It reminds me of the promoters who say: “Well, if it was a buy at 50 cents, it’s an even bigger buy at a nickel.”
The latest bubble, so we’re told, is dividends, on the grounds that stocks that pay them have done well. That’s all it takes to be dangerously overbought.
I think the pundits are wrong. Dividends are in a bull market, not a bubble, and the bull market is still in its early stages.
Here’s why: Ben Bernanke doesn’t give stock advice that I know of, but he’s giving us a pretty strong hint about where to put money. The short answer is not in fixed income. He and other central bankers around the world are determined to keep interest rates as close to zero as possible, and he’s not shy about saying so. Central banks have little choice: If rates go up governments go broke and some consumers and businesses are in trouble, too. Although the Western world’s governments have more debt than ever, their interest payments are smaller than when their debts were much lower. Higher rates would bankrupt them, not to mention some of their citizens and corporations. When Mr. Bernanke says rates are staying low until late 2014, I think that means indefinitely.
If you’re with me on this, let’s connect the dots, from central bankers in ivory towers to a 70-year-old retiree who’s dependent on fixed income to buy groceries and gasoline. He’s in good health and could easily live another 20 years. He got roughed up in the market crash of 2000, then timidly came back only to get pummelled by the end of income trusts and then the financial crisis. Badly depleted, he fled the stock market entirely four years ago. He tightened his belt and bought bonds and GICs three or four years ago, when rates, although not exactly luxurious, were a lot higher than today.
Now his fixed-income paper is maturing and if he wants to roll it over he’ll have to do so into new GICs or bonds paying a third or even a quarter of what he was getting before. In other words, his income shrinks drastically.
Can he afford this? Highly unlikely, unless he goes to work as a greeter at Wal-Mart. So what’s he going to do? I think he has to come back to equities – not the riskier ones but those that pay dividends. There are perfectly good firms whose stocks yield 5 per cent or more. Are they riskier than GICs? Yes. Enough to warrant a yield that’s five or seven times higher? Highly debatable, and in my humble opinion no.
If you agree with me so far, you have to think that a lot of money is going to be flowing into dividend stocks as long as rates stay low (they may rise a little but not much, in my view). That will drive the price of these stocks up and the yields down (remember that the higher the price, all else equal, the lower the yield).
This has already started to happen, as our bubble-spotters have made clear. But here’s why it will continue: The question is not how well has a stock done. The question is how does its yield compare with fixed income.
Let’s look at BCE Inc. for instance. The company pays 5.5 per cent. It’s not a particularly risky business; the amount we spend on telecommunications goes up every year. Yes, Bell is losing landlines but it finds a way to raise its dividend pretty reliably. The stock, meanwhile, has done very well, rising 12 per cent over the past year.
How is that possible given that BCE is hardly a growth story? Simple. Investors are slowly telling themselves that the difference between the yield on fixed income and stable equities is too high.
And here’s the funny thing about dividend yields: A very slight change can lead to a big change in the stock price. If investors were to decide, as I suspect, that a 4.5-per-cent yield is acceptable, BCE’s stock would go up 20 per cent for a total return of about 25 per cent.
That’s pretty good. But you can get even better returns from low-growth companies if you move down the market-cap ladder. One stock we’ve recommended in our investment letter is Boston Pizza Royalties. It has delivered an almost 40-per-cent return in six months, and in my view isn’t done yet (I own some). This is a small but wonderful business, and it doesn’t really care what happens in Greece or China or Wall Street, unlike our supposedly safe, dividend-rich bank shares. The yield stands at 7 per cent and the dividend was just increased. If it’s bumped up again in a year by the same modest amount and investors decide they can live with a 6.5-per-cent yield, the investment will deliver a 20-per-cent gain.
I think investors have a unique opportunity: big returns from relatively safe, low-growth businesses. Now is not the time to be afraid of the stock market.
Fabrice Taylor, CFA, publishes the President’s Club investment letter. His letter and The Globe and Mail have a distribution agreement.