What To Do With Overvalued Dividend Paying Stocks?

The hunt for yield in a low-interest rate environment has pushed conservative income investors out of Treasury and corporate bonds and into dividend paying stocks. “Bond-like” equities.

So many income seeking investors have moved into dividend paying utility and consumer staple stocks that they are now one of the most crowded trades in the market.

Two of the most crowded sectors right now are consumer staples and utilities, according to analysis by Vadim Zlotnikov, a co-head of multi-asset solutions and chief market strategist at AllianceBernstein LP. Such stocks have been popular this year because their regular dividend payouts make them attractive as income-bearing substitutes for bonds. Utilities are the second-best-performing sector of the S&P 500 so far in 2016, rising 15%.

Chart courtesy of WSJ. Click image to enlarge.
Chart courtesy of WSJ. Click image to enlarge.

Crowded Trade = Overvalued Asset

Investors crowding into an asset class leads to overvaluation. “Safe” dividend paying stocks are reaching rich valuations as Intrinsic Investing points out with WD-40 (WDFC).

The dividend generating power of WD-40 is essentially unchanged from 2001-2016. Nothing much has changed in terms of demand for their products nor the competitive landscape. Growth expectations for the years ahead are no different from the low, but steady growth that has characterized the last 15 years. But today, investors are paying twice as much for each dollar of earnings as they did during the period prior to the financial crisis. We see a similar willingness to pay excessively high valuations for “safe”, income producing assets in the behavior of the 10-year treasury yield with the yield falling from 5% in 2007 to 3% in 2013 to just 1.5% today. This is the equivalent of the PE ratio on the 10-year treasury going from 20x during the 2001-2007 time period to 33x in 2013 to 67x today.

Here’s a chart that displays WD-40’s PE ratio over the last two decades.

WDFC PE Ratio
Chart courtesy of Intrinsic Investing. Click image to enlarge.

Our job is now harder.

Our job is to invest for current income and dividend growth. We only invest when we think a company is trading below our estimate of its intrinsic value. We just can’t pay any price for income. Overpaying for “safe” income producing assets has the unintended consequence of making them unsafe. When future returns can not justify the high current price the downward readjustment of its price overrides the returns from income leaving investors with negative total returns.

In a perfect world, we would sell our richly valued positions and move the proceeds into a new undervalued high-quality dividend paying stock. The world is never perfect.

We are finding it harder and harder to find new positions top invest in. We follow a lot of companies that we would like to own at the right price but few are trading near that price.

What Do We Do?

Do we sell the richly valued positions and sit in cash while we wait for a price correction? Do we take the hit to current income in the hope to buy a little more income at a better price? What if the correction we want in order to put our cash to work doesn’t happen for a long time?

If you asked 10 different money managers you would get 10 different answers to these question. Everyone has their own style.

What We’re Doing

Waiting for Something Better

We have positions that we would be willing to sell today if a better investment opportunity presented itself. These positions are not drastically overvalued, they’re generating income, so we’re just waiting for a better opportunity. We’re working on one new idea right now. While we finish up our due diligence we’re willing to hold onto our current position(s) because of the income it is producing for us.

Trimming Around the Margin

If a position in an account has grown to a size outside our acceptable range and/or if its overvalued, we will sell some of it to bring it back down to our target weight. But we’ll only do this when the dollar amount being sold meets a certain size threshold. Trading commissions are low but they can add up and it’s for that reason we don’t like to do a bunch of small trades. We’re willing to do some trades at a certain size because the trading costs as a % of the total trade will be very small.

Outright Sell

When a position is so overvalued that the probability for negative future total returns is high we will sell all of it.

Howard Marks made the comment that every asset is triple-A rated at the right price. The inverse is true too. Any asset can be a toxic asset at the wrong price.

We may love the company. We may love its market position and future prospects but if the price of its stock is so high that it can’t grow into its expectations the prudent thing to do is to sell the position.

Will we get the timing right on an outright sell? No. We’ll likely sell way too early as the crowded trade gets even more crowded.

Sources:

WD-40: A Case Study of the Bubble in “Safe” Stocks (Intrinsic Investing)

Popular Investments Are Ripe for a Fall (WSJ)

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