A global correction in high dividend-yielding stocks has done little to weaken the common investor's devotion to income equity strategies, according to some investing professionals.
The pursuit of yield in the stock market has flourished in an era of ultra-low interest rates, which have given rise to the need for additional sources of income to replace those once provided by savings and fixed-income securities.
But there are risks associated with reaching for yield, which many investors are ignoring, said Jason Donville, president at Donville Kent Asset Management.
"We're seeing people chasing stocks that have attractive dividend yields indiscriminate of anything else going on in the company."
While high-yield stocks have generated decent returns over most of the market's recovery from the global financial crisis, evidence is mounting that investors have become myopic in their pursuit of income, according to veteran Wall Street strategist Richard Bernstein of Richard Bernstein Advisors.
"Strategies based on stretching for yield have a long history of surprising investors with unanticipated risks," he said in a recent note. "However, it does not appear as though most investors share our concern. In fact, some credit-related asset classes are still considered 'safe' or 'opportunistic' by many investors."
Investors, Mr. Bernstein suggests, need to take their cues from the credit cycle.
In the decade prior to the global financial crisis, the global expansion of credit fuelled outperformance in what he calls "credit related asset classes" – gold and other commodities, emerging market equities, REITs, hedge funds and private equity.
In the case of commodities, for example, credit expansion tends to spur demand for raw materials, while also generating inflation, which in turn benefits commodities' securities as investors gravitate toward real assets.
Since the end of 2008, however, those asset classes have all lagged the S&P 500 index, dramatically so in the case of commodities.
And yet, most investors still treat those asset classes as they did a decade ago, ignoring "the ramifications of the deflating global credit bubble," Mr. Bernstein said. In the case of stocks, few investors have questioned the sustainability of high dividends even through a period of shrinking access to credit. "Higher yield equity strategies remain immensely popular despite the risks associated with such strategies."
Between the time the U.S. market bottomed out in March, 2009, and July, 2014, the MSCI World High Dividend Yield index rose by about 160 per cent. In the year that followed, it fell by 10.5 per cent. Calling that a correction, Mr. Bernstein does not rule out a "full-blown bear market."
That index has rallied somewhat since early July, but the downside of the credit cycle remains the firm's "primary investing focus," he said.
In the Canadian market, many stocks tied to rich dividends look overvalued, Mr. Donville said.
When dividend payouts are too high, it leaves insufficient profits left over to sustain growth in the business. That both limits the stock's potential capital gains and makes future dividend hikes less likely, he said. "They're essentially buying a 4-per-cent bond at a really rich premium to par value."
Plus, high-yielders are vulnerable to an amplified selloff if something goes wrong. DirectCash Payments Inc., for example, posted a big first-quarter earnings miss in mid-May, when the stock was yielding about 8 per cent. The reduced earnings outlook for the company then pushed its dividend payout ratio to levels unacceptable to many fund managers, who had no choice but to sell, Mr. Donville said. The stock sunk by 31 per cent over the following two months.
While he calls himself "dividend agnostic," he said his stock screening model rarely spits out high-yielding Canadian stocks as buying opportunities these days. That shift away from income toward growth has been on for more than two years now.
That strategy seems to be working. Donville Kent's Capital Ideas fund has returned 36.3 per cent over the last two years, compared to 12.8 per cent for the S&P/TSX Total Return index. In the last year, the fund has posted a 22.9-per-cent return, compared to a 1.2 per cent loss for the index.
The dividend payers he does invest in tend to have low payout ratios, like Alimentation Couche-Tard Inc., which uses most of its profits to pursue growth. But for many income investors, Couche-Tard's 0.4-per-cent dividend yield just isn't fat enough.
"You're not getting as much in hand, but as Buffett says, you could always just sell some of your shares at the end of the year, and get your income there effectively," Mr. Donville said.
Tim Shufelt