Dividends: The Next Bubble?
By Ed Perks, Don Taylor
August 31, 2012
Dividend-paying stocks have received a good deal of attention this year—and for good reason. The economically challenging and yield scarce environment has driven many investors to flock to these types of investments. Some pundits are even suggesting a bubble may be building, and we all know what eventually happens when bubbles get too big. Ed Perks, senior vice president and director of the Core Hybrid Portfolio Management Group at Franklin Templeton, and Don Taylor, senior vice president and portfolio manager for Franklin Equity Group®, suspect it’s these fearful prognostications that are overinflated, not the asset class. As they see it, the dividend-paying stock universe is expanding, and deserves investor attention.
The attention given to dividend investing is certainly understandable. When investors are nervous and uncertain, they tend to gravitate toward investments they perceive as more stable, including traditional dividend-paying stock sectors like utilities and telecommunications. At the same time, retirees seeking income but finding less to be had among traditional fixed income investments are looking for alternatives. However, just because investors are pouring money into dividend-paying stocks doesn’t necessarily mean there’s a bubble forming. Perks explains why:
“I think if you were to just look at the attention being given to that topic by the media, certainly you would think that might very well be the case, but as we look at it, we really don’t see that. Looking at where money is flowing into the markets, we generally still see a strong predominance of the cash flowing into fixed income products, not equity products.
That said, there are certainly yield-oriented equity strategies that have been performing well and that investors certainly have been more attracted relative to, say, more growth-oriented equity products. We do see some areas in the market—I would call these maybe the historically or traditionally high-dividend paying sectors (including telecoms, utilities and perhaps some consumer staples)—that have benefited the last several months. Today those companies may be trading at the upper end of historical valuation ranges, and they still have very attractive dividend yields, but maybe not as much total return opportunity.”
Given the trifecta of the European debt crisis, slowing growth in China and “fiscal cliff,” fears in the U.S. it’s certainly understandable that investors are placing what they see as more conservative bets. The trend could continue to benefit dividend-paying stocks, says Perks, who manages Franklin Income Fund, noting that dividend-paying stocks are expanding beyond traditional sectors.
“We think that puts dividends and buybacks in a better light and likely to continue to get a strong focus. Historically if you were looking for high dividend yields, I think you were more constrained; you had fewer sectors that you could look at to achieve that. It’s partly a function of where long-term interest rates are and the very low yields in parts of the fixed income market, but companies have really shifted their orientation. We really think today the opportunity set from which to find attractive yields in the equity markets has broadened. We do not think that on an overall basis there is a bubble forming. If anything, we really like the opportunity to look across a wide range of the market, and we are finding opportunities.”
Even if the universe of dividend-paying stocks is expanding, uncovering good values with long-term potential can be daunting. Remember, there is no guarantee a stock that paid a dividend in the past will continue to do so in the future. Don Taylor, who is also lead portfolio manager for Franklin Rising Dividends Fund and spends a good deal of time looking for dividend-paying stocks that he believes can keep on paying, explains his screening process:
“We look for companies with consistent dividend increases and substantial dividend increases. We define ‘consistent’ as companies that have increased their dividend at least eight out of the last 10 years without a dividend cut during that time and ‘substantial’ meaning dividends that have increased—at least doubled—over the last 10 years. In selecting companies for the portfolio we think in terms of identifying companies we think will continue to have consistent and substantial dividend increases going forward.
Next are strong balance sheets and reinvested earnings. We screen for companies that have long-term debt to total capitalization of no more than 50% and payout ratios of no more than 65%. Typically the payout ratio may be more like a third of the earnings, so most of the earnings and cash flow is going for reinvestment back into the business.
And a final screening is a relatively low price-to-earnings ratio relative to its own history. We screen for companies that are in the lower half of their own absolute 10-year price-to-earnings range. So if a P/E ratio has been between 10 -20 over the last 10 years, we would be screening for companies at 15 or lower.”
It really all boils down to analyzing each individual company or investment on its own merit, and taking a long-term perspective regardless of what the crowd may be doing today. That philosophy is something Sir John Templeton espoused: “Experience teaches us that one of the most common errors in selecting stocks for purchase, or for sale, is the tendency to emphasize only the most obvious factor, namely, the temporary outlook for sales and profits of the company.”
What Are the Risks?
All investments involve risks, including possible loss of principal. Investing in dividend-paying stocks involves risks. Companies cannot assure or guarantee a certain rate of return or dividend yield; they can increase, decrease or totally eliminate their dividends without notice. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.
Franklin Rising Dividends Fund invests in value securities, which may not increase in price as anticipated or may decline further in value. While smaller and midsize companies may offer substantial opportunities for capital growth, they also involve heightened risks and should be considered speculative. Historically, smaller- and midsize- company securities have been more volatile in price than larger company securities, especially over the short term. These and other risks are detailed in the Franklin Rising Dividends Fund’s prospectus.
Franklin Income Fund’s portfolio includes a substantial portion of higher-yielding, lower-rated corporate bonds because of the relatively higher yields they offer. These securities carry a greater degree of credit risk relative to investment-grade securities. The fund’s share price and yield will be affected by interest rate movements. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in the fund adjust to a rise in interest rates, the fund’s share price may decline. These and other risks are detailed in the Franklin Income Fund’s prospectus.
(c) Franklin Templeton Investments