Sun, 28 Jul 2013
A rising-rate environment has historically led dividend payers to underperform, but that is no reason to abandon these high-quality companies, says Morningstar's Josh Peters.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He is the director of equity income strategy here at Morningstar and also the editor of Morningstar DividendInvestor. We're going to talk about what impact rising rates will have on dividend-paying stocks.
Josh, thanks for joining me today.
Josh Peters: Good to be here, Jeremy.
Glaser: You've looked back at some previous rising-rate cycles and what impact that's had on higher-yielding sectors. What did you find in that research?
Peters: My look back at rate cycles over the last 20 years did come up with some pretty predictable results, which is that you see a pattern that higher-yielding stocks and higher-yielding sectors within the market tend to underperform a broad market benchmark like the S&P 500 when interest rates are rising. And I used for that reference the 10-year Treasury yield that goes up more than 1 percentage point from the bottom.
On average during these cycles, the S&P 500 has a total return of 11%, which is pretty good. It makes you wonder why investors, in general, should be so worried about rising interest rates. The Dow Jones U.S. Select Dividend Index on the other hand, which is a pretty good benchmark and goes back to the end of 1992, covering this high-yield sector of the market, has had an average total return in these periods of only 3.7%. On average, it's still positive. But there's not much capital appreciation, but there is that relative underperformance.
However, within the numbers, depending on how you want to treat different rate cycles, I actually think that it's not even that bad. If we exclude a couple of really unusual periods--the immediate post-crash period in 2009 as well as the dot-com bubble era where anything and everything that was associated with old economy, including dividends, was tossed out in the trash--then you have a pretty comparable level of performance. On higher-yielding stocks, the Dow Jones Select Dividend Index only underperformed by a little less than 100 basis points during those rate cycles.
I think having come this far in this rate cycle--long-term interest rates are already up a full percentage point or more from the bottom--we've seen the same pattern hold true. High-yield stocks have underperformed, but you're still making money. You're still collecting the dividends, and even if you're not getting as much capital appreciation as the rest of market, you're still getting some.
Glaser: Utilities have been hit particularly hard recently. Has that been the case through other cycles?
Peters: Yes, and that actually gets to the underlying reason why higher-yielding stocks tend to underperform in an interest-rate cycle. It's not just that interest rates are going up and that the natural buyers of utilities stocks, consumer staples stocks, or telecom stocks would also be potential buyers of bonds and are just shifting their money out because interest rates are going up. It's also because that these are typically economically defensive, high-quality businesses. Their earnings tend not to go down that much in recessions, in periods of economic or financial stress. As the economy recovers, which is typically associated with a rise in long-term interest rates, they don't have as much to gain back because they didn't lose it in the first place.
Utilities definitely fit that that profile. You don't have a lot of earnings downside in recessions. You do have a little. You do have a little bit of a bounce back when the economy recovers and, say, industrial power demand goes up. But at the margin it's not a real big impact. Therefore you see investors, just as the market passes through cycles, decide to go off and chase perhaps faster-growing, more cyclical, or more speculative investments.
But that's not necessarily how you want to frame a portfolio. I think you want to think over many cycles what kind of companies do I want to own? What kind of companies can I afford and know I can keep even when share prices are falling? I think for most investors, they're still better off with those defensive stocks through the boom times and the bust times as opposed to going out and trying to time cyclical sentiment shifts in the market.
Glaser: Has this underperformance created any opportunities to pick up some of those defensive stocks?
Peters: The interesting point here is that even though they have underperformed relative to the rest of the market over the last couple of months, which has made them somewhat more appealing on a relative basis, share prices have still gone up in general, and there aren't a whole lot of what you call flat-out bargains.
But there are plenty of what I would call good deals, companies like American Electric Power in the utility area, predominantly a regulated utility. It had a little bit of an earnings decline because of the recession. They've concentrated a lot of their businesses in Ohio and Indiana, states where manufacturing is heavy. They have the opportunity to bounce back a little bit in a better economy. But you've also got management raising the company's payout ratio target to 60% to 70% range, which is still very safe, given their earnings profile, but it's going to allow them to raise the dividend faster over the next couple of years than they would have otherwise. And you're getting a yield of over 4%.
Also I like a name like Clorox. Yes, people are not going to use a whole lot more bleach just because the economy happens to be growing faster, but it's a great collection of brands that throws off great cash flow. There is a very strong management team here that does a wonderful job allocating capital and really prioritizes dividends as a way to reward shareholders for their capital being in Clorox. I like a name like that, and you're on the low-3% [yield] area.
These are the kinds of names I'm willing to ride through whatever happens next, and the fact is we just don't know. Long-term interest rates have gone up, but there are not much signs that the economy is growing faster. There are even less signs that there are inflationary pressures out there. If interest rates continue to rise from here, we might not be worrying so much about interest rates going up as the fact that we could have a recession triggered by a mistake in monetary policy.
You have to put all of the potential outcomes on the table, not just think in terms of interest rates going up indefinitely, and look to suit your portfolio to what you're trying to accomplish over the long run with your money.
Glaser: Josh, thanks for sharing your thoughts with us today.
Peters: Thank you, too, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.