Why Dividend Stocks are Cheap

And their prospective rewards are compelling.

“Swap your dividend stocks for growth funds. If you need income, you can always sell a piece.”

More than a few professionals dished out that advice in the late 1990s. And it worked—at least until the Great Tech Wreck of 2000-02 crashed the market leaders and forced a generation of investors to “eat their seed corn.”

Dumping stocks of “staid” high yielding companies for current market favorites with upside momentum is decidedly back in fashion now. And the longer the trend lasts, the more income investors will be tempted to up-end long-held strategies and to load up on the market’s current favorites.

Today’s leaders are usually tomorrow’s laggards. Today’s leading big technology stocks, for example, were huge losers last year.

Performance of best-in-class dividend paying stocks has been considerably steadier since the pandemic year of 2020. Nonetheless, they’re having a lot of trouble attracting buyers, as investors have adopted a narrative based on six key points:

·       Benchmark interest rates are going to remain higher for longer, quite possibly for several years.

·       Companies that have historically relied on debt finance will find it progressively more difficult to meet near and long-term earnings guidance.

·       The US economy may avoid the dreaded “hard landing” but more cyclical sectors are seeing a revenue slowdown that’s likely to get considerably worse for many companies.

·       Above average dividend yields are not to be trusted, meaning the further a stock’s price sinks the more its payout is deemed to be at risk.

·       Equities exposure is best in stocks with momentum, regardless of valuation.

I don’t have a problem with any of these points per se. But they do over simplify.

There’s no question Federal Reserve governors believe their now 18-month-old policy of increases is succeeding in bringing inflation under control. And in fact, data released last week would seem to back them up, which means little chance they’ll reverse course anytime soon.

The July Consumer Price Index excluding prices of food and energy rose by just 0.2 percent for a second consecutive month. That’s the smallest back-to-back gains in more than two years.

But nothing the Fed has done addresses the core causes of inflation, which all have to do with a lack of investment. In fact, by raising rates, the central bank has arguably crushed the very investment needed to bring supply and underlying demand back into balance for energy and housing, as well as to build new supply chains to compensate for attempted decoupling from China.

That means inflation is likely to come roaring back stronger than ever, just as it did following even larger rate hikes in the late 1960s, early 70s and the late 70s. And as a result, interest rates are likely to remain higher for longer.

The economy may indeed avoid a hard landing by conventional definitions. But the combination of higher borrowing costs and paying more for food and fuel continues to cut into consumers’ buying power, which affects businesses negatively up and down the value chain. In fact, some sectors and companies are already in recession. And conditions are likely to worsen the longer the Fed keeps interest rates at elevated levels.

That’s already challenging some companies’ ability to pay their current rate of dividends. Companies with substantial debt to refinance and/or that rely on variable rate borrowings/credit lines, for example, are paying much more in interest expense, undermining earnings and balance sheets. And that means there’s good reason to look skeptically at abnormally high yields, especially with money market funds as a risk-free alternative yielding over 5 percent.

Small wonder then that investors—even many who rely on portfolio income—aren’t value hunting high yields and low price/earnings ratios. That’s despite so many established dividend stocks on the bargain heap now, including companies with established franchises and investment grade balance sheets that have only raised and never cut dividends.

The technical picture for these stocks is as poor as it’s been in memory. And so long as current market narratives prevail, it will stay that way. Not a pretty picture, but not a good reason for abandoning best in class dividend paying stocks.

How can you tell the difference between a company that’s holding up on the inside and one that’s faltering? One of the best signs of resilience is ability to deliver on previous earnings guidance.

To clarify, I’m not talking about Wall Street projections for earnings, which the media quotes when numbers are reported. Rather, it’s what management itself has said and how well the company has delivered on it.

At the beginning of 2023, many investors were convinced the Federal Reserve was winning its battle against inflation and expected interest rate cuts later this year. That’s proven wildly optimistic. In fact, weakness in banks and commercial real estate have further tightened credit conditions.

That’s meant higher than expected interest expense for many companies, even as stubbornly high inflation has eaten away at revenue while pushing up operating costs. Nonetheless, only one of the dividend paying stocks in our model Capitalist Times income portfolio cut 2023 guidance following the release of Q2 results. And that was the result of very poor wind conditions.

Ability to stick to projections for the bottom line isn’t everything. But it shows management planned and insulated well enough to keep its operating and financial plans intact. And that’s the best possible indication the company can keep paying its dividend. Even guidance cutting Clearway Energy (NYSE: CWEN), for example, was able to boost its dividend in line with previous projections.

Five other factors I focus on to determine the strength of dividend stocks: Long-term sustainability of dividend policy, reliability of revenue based on the nature of the business, regulatory/legal considerations, debt refinancing risk and operating efficiency.

Each is connected to the others. For example, more efficiently run companies tend to have fewer regulatory concerns, reliable revenue means stronger balance sheets and so on.

The key is how well they fit together. And for investors, fitting together well means there’s no reason to doubt the strength of the dividend, regardless of how high the yield is. Momentum notwithstanding, it makes no sense to sell. And patient buyers will be doing so very close to a major bottom.