For many dividend-payingstocks , it appears as if a "great
rotation" has begun.
One of the most lucrativeinvesting themes of the past few years
may be coming to an end as interest rates start to rise,
heightening the relative appeal offixed-income assets compared
with riskierequities .
The question for investors: As others start to flee, how can you
know when it's time to go against the grain andload up on
Let's be clear: Not all investors think we're on the cusp of a
sea change in interest rates. The globaleconomy remains quite
weak, with Europe stumbling to find an economic floor and China
showing increasing signs of weakness. As long as the global
economy is in a funk, some strategists expect that U.S.
investorswill continue to benefit from an environment of
ultra-low interest rates. A few have suggested thatbonds mayrally
anew in coming months as the reality of a still-troubled global
economy once again dominates investor sentiment.
But I am not in that camp.
Despite the global headwinds, the U.S. economy is slowly gaining
traction. The broad consensus amongeconomists calls for the
economy to grow in excess of 2.5% in the second half of thisyear
and approach 3% growth in 2014. Once Europe and China reverse
course, the global trade tailwind may become a headwind, perhaps
nudging the United States toward 3.5%GDP growth by 2015. Against
that backdrop, it's hard to see how interest rates (both short
and long-term) can stay near multi-decade lows.
The problem with rising rates -- and the possible diminished
appeal they will create for dividend-paying stocks -- is
negativecapital appreciation . If astock yields 5% but loses 15%
of its value, then investors will be looking at 10% total loss.
For instance, the subsector known asmortgage real estate
investment trusts (MREITs) has had such a bad month that a year's
worth of robust annualdividend payments has already beenoffset by
the month's trading losses.
(For an intriguing discussion of this subsector, read my
colleague Chad Tracy's column on MREITs, in which he argues that
"most of investors' fears for the future have already been baked
into current prices.")
Chad makes an important point about downside protection, citing
thebalance sheet of
assupport for this stock. Annaly'smarket value has fallen close
to 20% since September, to $12.9 billion. Yet the net value of
Annaly'scash andbond holdings exceeds $15 billion.Note that these
bonds are carried on the booksat par value and will not need to
be written down as long as Annaly chooses to hold them tomaturity
and they don't suffer from freshdefaults .
Can this stock fall further? It could, but over time, it's likely
to find its way back tobook value simply because management can
reinvest the proceeds from maturing bonds into buybacks (which
are always accretive whenshares trade below tangible book value).
Moving past the MREITs for now (as Chad has covered that group
extensively), what kinds of signposts can we look for in other
dividend producers that don't use borrowedfunds to juice their
returns and fuel their dividends?
We can look two to kinds of stocks: first, companies such as
or electric utilities, such as
Con Edison (
, that sport stable but very slow-growing dividends. The second
group: companies with lower yields but a path toward higher
Let's focus on the first group. AT&T might be the kind of
slow dividend grower you'd seek to avoid, simply because telecom
service providers face huge long-term challenges as landlines get
turned off. Sure, AT&T has a solid wireless division, but
cracks in the armor are appearing.Earnings before interest,taxes
,depreciation andamortization (EBITDA ), which stood above $40
billion in 2009, 2010 and 2011, fell to $32 billion in 2012.
Although AT&T has managed to boost its dividend for many
years in a row, that streak will have to end soon if this company
can't figure out new paths to growth.
In contrast, electric utilities like Con Edison are extremely
fortunate. They are granted profit-preserving rate hikes by
regulators, which enables them to boost their dividend by a
modest amount every year.
Still, thanks to the rotation out of dividend-paying stocks, even
Con Ed hasn't been spared, with its shares falling nearly 10%
since early May. That's pushed thedividend yield up to 4.3%. As a
point of reference, that's still above the averageyield of the
10-yearTreasury note over the past 10 years. Sure, rates moved
above 5% for a few years when the economy was booming in the past
decade. But few expect to see a booming economy again for quite
awhile, which means the 10-yearTreasury bond is likely to stay
below 4% for the foreseeable future.
Risks to Consider:
The Fed 's aggressive quantitative-easing programs are
expected to wind down in comingquarters . If that unwinding
doesn't proceed in an orderly fashion, then the bondmarket may
get routed, sucking funds out of dividend-paying stocks.
Action to Take -->
Thinking about a 4% Treasury yield is a good marker for these
times. As long as a stock yields more than that, and as long as
the business has a wide enough moat, then it shouldn't scare you
In a follow-up to this column, I'll be looking at a tech sector
with current dividend yields typically below that 4% threshold
but sufficiently robust growth prospects to create much higher
payouts in the years to come.
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