The Hunt for Yield Part One: Can Dividends Continue to Grow?

“Those wounds are all the painful places where we fought. Battles better left behind, ones we never sought. What is it that we spent and what was it we bought?”

-Frank Herbert

What quote could better serve up the dilemma facing investment managers as another week of new highs for the S&P 500 which has them wondering, “to chase or not to chase?”  One the one hand, you have a line-up of investment greats like Byron Wein and Jeff Gundlach who think stocks are overbought, not to mention a likely fifth consecutive quarter of declining earnings and on the other…well you have demanding clients who see the market higher and want to participate or an angry MD telling you to clean out your desk if you’re not in the upper quartile this year.  So what do you do?  Well according to Bank of America (via Zero Hedge), you buy with both hands and hold on as investors have finally begun to pour billions back into high yield, EM debt and equity ETF’s to get a piece of the action even as the S&P 500 made a new weekly high on lower volume.

If BofA’s information is correct, a lot of investors are going to be engaging in that time honored practice that a behavioral specialist would call “herding” or rushing to find assets just as the market is making new high for fear of being left out.  Think of it as either there’s safety in the herd or that you can’t get fired for doing the same thing that everyone else is doing!  And just think about how much that brilliance is going to cost you in management fees this year.

Some strategists would tell you that if you can’t resist pulling the trigger (or because you don’t want to wind up in the lower quartile 2016 and the bread line in 2017) then you should focus either on finding pockets of value or buying high quality dividend payers, but it’s hard to say the market has a lot of pockets of value left with the S&P 500’s trailing P/E at just under 25 or the cyclical adjusted P/E at 26.9 and with more than 77% of the broader NYSE trading above its 200 day moving average.  Even the S&P 500’s current dividend yield of 2.03% is only “attractive” in a relative sense when compared to a 1.59% yield on a ten-year Treasury.

Now obviously from the title of this post, this is just the first part in our quest for high dividend payers and then trying to find existing fund offerings with heavy concentrations of those names but before you can understand how limited your options are, you need to learn just how extreme the dividend situation has gotten.  Most of the headlines recently have been about how low the dividend yields are for traditional safehaven sectors like consumer staples and utilities but focusing on those two sectors is like missing the forest for the trees.  There are two much bigger issues facing yield-oriented investors these days.

The first is that the amount of money being paid out as dividends isn’t likely to continue growing at the same rate it has over the last decade.  Ever since the Bush tax reforms of 2003, qualified dividends have been taxed at the same rate as capital gains which has triggered a veritable avalanche of money as most corporations have shifted their focus from growing their businesses to simply paying out dividends.  You can see in the chart below that from 1988 to 2Q 2003, S&P 500 dividends per share grew around 4.6% per year while the broader economy (measured by gross domestic income) grew around 5.6% which makes sense as dividend payouts can’t grow faster than the broader economy for a prolonged period of time.  Fast forward to the post-Bush tax reform era and you’ll see that dividends have been growing at over 11.65% per year while economic growth has slowed drastically to 3.9%!

DIV1

So how extreme has the situation become?  Check out the latest edition of Factset’s Quarterly Dividend Report (here) and Quarterly Buyback Report (here) but to give you the highlight reel:

  • Fewer than 80 companies in the S&P 500 currently pay no dividends while 44 are paying more than 100% of their earnings.
  • The aggregate TTM payout ratio for the S&P 500 was 39.1%, up 12% year-over-year and the highest level since Q3 2009 when collapsing earnings pushed the payout ratio to 50%. This is also the highest level it’s been in recent history without the economy coming out of a recession.
  • Most of the growth in DPS came from the healthcare and financial sectors which have been hard pressed in the first six months of 2016 and the most optimistic forecasts for financial stocks are for flat earnings in 2016 compared to 2015.
  • This might seem to mean that there’s still room to grow dividends except for the fact that buybacks have soaked up even more capital than dividends over the last few years! The TTM buyback yield through Q1 was just under 80% and nearly 150 S&P 500 components spent more on buybacks than they earned in net income!
  • Buybacks and dividends paid in the first quarter soaked up $280.2 billion compared to $189 billion in reported net income for that quarter.  Zoinks!
  • The net effect of all these buybacks has been to decrease the number of shares outstanding by just under 2% over the last year. Great boost to EPS.

If that sounds pretty grim, you might want to hold onto your hats because paying out a dividend is one thing but being able to KEEP paying out that money is another and that’s where the situation is becoming more troubling.  Brute logic would tell you that in the long run, dividends can only grow as fast as the broader economy and companies have defied this logic until now through financial engineering to take on more debt and payout more in dividends but could the weak global economy be about to catch up to them?

The analysts at Factset certainly think so as the as year-over-year growth in DPS dropped to 7.5% in Q1 which was the second consecutive quarter of single-digit growth as four consecutive quarters of declining earnings eats into the ability of companies to continue their previous payouts.  Factset believes that the TTM rate will drop to just 4.9% by the end of Q2 and the most recent dividend update from Standard & Poors is giving them even more ammunition.  Through the first six months of 2016 S&P has noted there have been 1423 positive dividend announcements including increases, extra dividends or resumptions.  The problem?  That’s an 8.6% drop from the same period in 2015 which even then was a 12% drop from 2014.

Even that is only half the story as the number of companies with a “negative” announcement have skyrocketed with 410 reductions or omissions in 2016, a nearly 60% increase compared to the first six months of 2015 which also saw a 60% increase compared to the same time frame in 2014.  Another way of considering our dilemma is by looking at a ratio of the two which currently stands at 3.47, less than a third of what it was in 2014 and the lowest reading for this time of year since 2009!

DIV2

So let’s recap, if you’re hungry for income, you can try to chase the broader market but remember you’ll be buying an income stream that’s unlikely to continue growing at anything like its recent rate while a large swathe of the biggest corporate names in America are already cutting back as a weakening economy means they won’t be able to continue their prior payout policies.  So we ask you again, what’s an investor to do?  You could either turtle up or stay tuned for our next piece on where to find companies with sustainable dividends for the future.

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