Trading Shots

Relax. There’s no dividend bubble.

The Globe and Mail

 

(Photos.com)

In his recent post “Yield-starved investors headed for income bubble burst,” Joe Timmath was right to warn investors about the dangers of rushing blindly into whatever fad the wealth management industry happens to be flogging.

Smart investors should indeed cast a skeptical eye at the new wave of income products, which are often structured to benefit the fund company and broker first, and the investor second. Some funds, for example, create the illusion of a high yield by returning the investor’s cash in the form of return of capital.

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Other funds jack up yield - and amplify risk - by loading up on junk bonds that could blow up if the issuer’s fortunes deteriorate or the economy heads south. Good for Mr. Timmath for pointing out that investors need to tread carefully.

What I don’t agree with is the article’s assertion that there is some sort of “income bubble” or that this episode “will end in tears.”

First, I should point out that I don’t invest in high-yield bonds. These securities are, by their very nature, risky. That’s why their yields are high. That said, high-yield debt has diversification benefits and portfolio managers with the expertise to evaluate credit risks can do quite well investing in them.

They’re just not my cup of tea. Being a conservative fellow, my fixed-income exposure is all guaranteed investment certificates. I ladder my GICs out five years, and when one matures, I reinvest the proceeds at the highest five-year rate I can find. True, yields are puny right now, but when they rise, I’ll be reinvesting at higher rates.

What I really want to focus on is the article’s assertion that dividend stocks - which account for the majority of my personal portfolio - are in a bubble. I don’t believe that for a moment. Yes, some valuations have gotten stretched. That’s always the case. But no, dividend stocks in general are not about to collapse. Here’s why.

Investment bubbles, or manias, have several characteristics in common. First, they are usually driven by speculation. People buy in the hope of flipping the asset - whether it’s a stock, a house or a tulip bulb - for a capital gain.

Second, leverage is a prominent feature of most investment manias; people are so seduced by the prospect of “easy” money that they borrow large sums of cash, which inflates the bubble further, drawing in more buyers, and so on, until the music stops.

But I don’t see a lot of speculation in dividend stocks right now. I do see retirees buying dividend-paying companies as a source of long-term income. Nor do I hear about people rushing to the bank for a loan to buy 1,000 shares of TransCanada Corp.

A third hallmark of investment bubbles is that traditional valuation metrics are thrown out the window. During the dot-com mania, for example, it wasn’t unusual to see companies trading at price-to-earnings ratios of 100 or more. Analysts and investors justified these insane multiples by claiming that the world had entered a new era where the old valuation rules no longer applied. They were wrong, of course, and gravity prevailed.

When I look at dividend-paying companies today, I don’t see outrageous P/Es. Canadian Utilities Ltd., for example, is trading at about 15.7 times next year’s estimates earnings. BCE’s forward P/E is about 13. Many of the big banks trade for 10 or 11 times next year’s earnings. These are not bubble-like valuations.

What’s more, if we were in a dividend bubble, you’d expect dividend yields to have fallen sharply. But that’s not the case, either. The S&P/TSX composite index is currently yielding about 3 per cent. That’s higher than the average yield of 2.44 per cent over the past 10 years, according to Bloomberg. Similarly, the S&P 500’s yield of 2.2 per cent is higher than the 10-year average of about 2 per cent. No sign of a bubble here.

That’s not to say people can’t get hurt investing in dividend stocks. Anybody who bought Yellow Media, Manulife, AGF Management or TransAlta before their share prices tanked knows that dividend stocks are not foolproof.

So by all means be careful out there. Do your homework. Stay diversified. Know your risk tolerance. Keep some money in cash and GICs or government bonds. Be prepared for market setbacks; they’ve happened before and they will happen again.

But don’t avoid dividend stocks because you think they’re in a bubble. The evidence just isn’t there.

Readers: Has the bubble talk scared you away from dividend stocks? Or are you confident that solid, dividend-paying companies are a sound long-term investment? Let us know what you think in the comments section.

Follow on Twitter: @johnheinzl