The last 12 months have been difficult for stock investors. The top 20% of dividend stocks within the S&P 500 Index returned 13.5% within the 12 months ended March. In comparison, the return of the broader S&P 500 is 29.9%.
My message to equity income investors is: hang in there. High-yield stocks are prone to perform higher next 12 months. History, inherent biases, reversion to the mean and the present market environment point to a comeback.
Figure 1: Top quintile of dividend yield
As of March 31, 2024; Note: 1QDY or top quintile of dividend yield. Source: S&P, Bloomberg & Wealth Enhancement Group
In the long run, buying stocks with high returns is a very good strategy. Over the past 30 years, the very best quintile of dividend stocks within the S&P 500 (20% or 100 stocks) has outperformed. From December 31, 1994 to March 31, 2024, stocks in the highest quintile returned 11.9% annually. Over the identical period, the S&P 500 returned 10.4% per 12 months. That’s a 1.5% premium for high-yield stocks.
While the highest fifth of dividend stocks are more volatile than the broader S&P 500, they’ve the same Sharpe ratio and, by design, have a much higher dividend yield.
An equity income strategy is usually categorized as a worth strategy since it tends to favor stocks with a lower price-to-book ratio. The highest dividend paying stocks have also outperformed the Russell 1000 Value Index over the period 1994 to 2024.
Not surprisingly, volatility is higher for stocks with the very best returns, given the one-factor model. It can be helpful so as to add a dividend growth metric to avoid putting distressed firms prone to cutting their dividend, but the main focus of this text is just on yield.
Figure 2: Top quintile of dividend yield with equally weighted stocks
A sector neutral strategy has also outperformed the S&P500 and Russell 1000 Value indices over the past 20 years, but to a lesser extent. Understandably, some sectors perform higher with this strategy than others, depending partially on the extent of high-yielding stocks within the sector. For example, the industrials and financials sectors perform well in a sector-neutral strategy, while the patron discretionary and technology sectors don’t.
Why have high-yield stocks outperformed?
There could also be several reasons for the historical outperformance of high yield stocks. First, behavioral economists have shown that many investors who need a source of income prefer automatic dividends fairly than homemade dividends obtained by selling a holding.
Second, Benjamin Graham identified that paying dividends forces company management to generate attractive returns while using capital properly. In other words, the prices for the management agency are reduced.
Third, nonqualified dividends are subject to the next tax rate than capital gains and subsequently, in theory, should include higher returns to compensate shareholders.
In conclusion, we suspect that many investors who deal with a stock’s exciting growth story and pay little attention to the boring dividends paid via earnings and money flow are likely exhibiting a narrow framing bias.
That is, price targets are routinely set by assigning a multiple of earnings. These objectives relate to growth with little regard to return on capital, which is an equally essential a part of the valuation metrics. Of course, an all-encompassing discounted money flow model or a dividend discount model valuation is best.
The outlook for dividend stocks is nice. Using mean reversion alone indicates an uptrend. Over the past 30 calendar years, the year-over-year one-year forward return correlation for the very best quintile of dividend stocks within the S&P 500 has been -0.3.
A mechanical reversal to the center exercise
If we all know that the return in 2023 was 6.9%, the 30-year average return was 11.9%, and the 30-year correlation was -0.3, we will naively predict a return of 13.5% for 2024 predict. [-0.3 (6.9%-11.9%) + 11.9%]. A return closer to the mean. The same calculation could be done for the S&P 500 to project a return of 10.0% in 2024.
This mechanical reversion to the mean suggests that top yield stocks will outperform this 12 months. However, it is vitally essential to contemplate what average you ought to return to. Two essential fundamental metrics are return on assets (ROA) and earnings growth. Over the past 30 years, the highest fifth of dividend stocks within the S&P 500 have delivered a median ROA of 4.4% and a one-year earnings per share (EPS) growth forecast of 8.1%.
Currently, their ROA is 3.6%. After bottoming out at 2.5% a 12 months ago, one-year EPS growth is now expected to be 11.9%. With ROA slightly below average and expected EPS growth above average, the underlying fundamentals at the moment are near normal, suggesting that the 30-year average return of 11.9% is an affordable specter for one represents reversal.
To calibrate the outlook for dividend stocks a step further, we will model return using several variables. Two of the higher aspects for predicting the one-year return of the highest dividend stocks within the S&P 500 are the dividend yield and year-over-year CPI (Consumer Price Index). The first row is a valuation benchmark and the second is a rough indicator of rates of interest. Both metrics correlate with the one-year dividend yield.
Currently, the dividend yield of the highest quintile of dividend stocks is on the 20-year average, while the CPI is above average year-over-year and declining (see Figure 2). If the consensus expectation that the patron price index will proceed to say no year-over-year next 12 months holds true, dividend stocks will profit.
Figure 3: Dividend yield, CPI and 12-month yield
As of March 31, 2024; Note: 1QDY or top quintile of dividend yield. Source: S&P, Bloomberg & Wealth Enhancement Group
While equity investors have endured a difficult period, within the context of the historical performance of dividend stocks, it was short-lived. I’ll repeat my message to investors in search of capital gains: hang in there. History, inherent biases, reversion to the mean and the present market environment point to a comeback.
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Image courtesy of Nick Webb. This file is licensed under the License Creative Commons Attribution 2.0 generic License. Circumcised.
