INSIGHTS

On December 23, 2013

Viewpoints from AAM – In 2014 Volatility, Stick With High-Quality Dividends

By: Matthew McCormick, Bahl & Gaynor

Investors appear fully ensconced in the “don’t worry, be happy” camp. Modest economic and earnings per share (EPS) growth seemingly placate any concerns and are turning recalcitrant bears into bulls. Volatility is only to the upside and equity indices continue to hit all-time highs. It has been good to be an equity investor as the S&P 500 is up over 29% year to date (after a 16% pop in 2012). The question on every investor’s mind is, “will it last?”

Bahl & Gaynor is in the camp that some investors will continue to chase returns and “invest” in low-quality stocks that lack consistent earnings per share and dividend growth – and driving the indices higher. They do so because they have been constantly rewarded (and encouraged by the Fed’s massive liquidity programs) for adding more “risk” to their portfolios since the market bottom on March 6, 2009. Thus, many investors have no qualms about valuations, fundamentals or the need for dividends in their portfolios because stocks like Netflix (NFLX) seem to only go up. Few care about NFLX’s 252.3x (x denotes “times”) trailing P/E (price per earnings), its 24.9x Price/Book and 0% dividend yield. They only see its 295.1% year-to-date performance (as of the end of November 2013) and keep on buying. They forget its -60.6% 2011 return.

Interestingly, of the top 15 year-to-date performers in the Standard & Poor’s 500 (S&P 500), only four stocks have dividends. At Bahl & Gaynor, we have a mantra that is worth repeating: “valuations, fundamentals and dividends do not matter – until it is all that matters!” Could seasonal upward bias, positive political news and lack of geopolitical unrest propel stocks higher? The answer is, “sure.” However, we do not recommend paying triple-digit P/Es for companies with little or no earnings, no dividend yields and questionable business models. This market environment reminds us somewhat of 1999 or 2007 when investors seemingly threw caution to the wind and bought into “bubbles” like dotcoms and housing.

Now is not the time to become super aggressive as we believe the “low-quality/non-dividend” trade will eventually cool. Case in point, the valuations and fundamentals for non-dividend-paying stocks within the S&P 500 are dubious. According to FactSet, the average trailing P/E for non-dividend stocks within the S&P 500 as of 11/30/13 was 27.7x (cap weighted). In comparison, the trailing P/E for dividend-paying stocks was 17.5x. The average trailing Price/Book for non-dividend stocks was 3.4x versus 2.5x (cap weighted) for dividend stocks. The S&P 500’s trailing P/E is 18.3x and Price/Book is 2.6x. Non-dividend stocks may be outperforming this year, but few would disagree they are extremely expensive. Eventually, they would have to have more earnings to justify their P/E valuations, or their prices should come back to reality.

When reality impacts low-quality, non-dividend stocks (e.g., 2000-2002, 2008 and 2011), these stocks suffer dramatically. We recommend taking profits from low-quality names and rotating into stocks with better valuations, fundamentals, and that have dividends.

Bottom line: Bahl & Gaynor believes the best course of action is to stick to our discipline. Sentiment should eventually shift and fundamentals should matter again. 2014 could be a bumpy ride as volatility is likely to increase, not decrease, in our opinion. Accordingly, we believe high-quality, dividend-paying stocks are one of the more predictable opportunities in a very unpredictable investment world. Though we are realistic about our economic/market outlook, we are extremely optimistic about the opportunity within the high-quality dividend space now and for the next several years.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com

The information contained herein is obtained from Bahl & Gaynor and believed to be reliable. The information is not warranted as to completeness and accuracy and is subject to change without notice. The foregoing has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security.

The views expressed in this commentary are not necessarily that of AAM.