While technological advancements help mankind seemingly bend nature’s rules, no technology or tool can help man defy the laws of physics. This same principle applies to investing, including dividend investing. Over the next several articles we will tie in the concepts of physics with dividend investing.
Investors have noticed the recent outperformance of Utilities and other high dividend paying stocks, but note that stocks, like physical tools, cannot fight the gravitational pull that weak earnings will inevitably have upon the market. Utility stocks, once seen as generally safer, may be becoming unhinged from their underlying market fundamentals, presenting unexpected risk to investors chasing yield. Because of this, as the market climbed the wall of worry in 2016, investors started showing strong demand for safe-haven assets. Low volatility ETFs investing in Utilities companies have exploded in popularity, attracting billions of dollars of inflows this year alone[1]. Some market pundits claim that higher valuations were caused by central bank policies leading to “TINA” stocks, or “there is no alternative”[2], pushing more investors into the market and increasing valuations. Other market commentators meanwhile posit that the rally in Utilities is purely excess in a yield-starved world. Whatever they believe though, investors across the board seem to be asking the same question: is the performance of Utility stocks supported by earnings, or are they stealing from the future?
The S&P 500 Utilities sector has rallied over 11% year-to-date, performing in the top quartile of all sectors for 2016. Unfortunately, there is lingering evidence of overextension in Utilities. First-quarter earnings in the Utilities sector declined by 2.2% compared to a fall of 6.6% for the S&P 500. At the same time, revenues in the Utility space declined by 1.2% compared to a fall of 1.1% for the S&P 500[3]. The Utilities sector rallied after the Brexit vote in June, and investors further poured into the sector after interest rates remained unchanged in September, pushing stock prices even higher.
Though signs of positivity in the Utilities sector exist, they are unlikely to be sufficient to overcome sector headwinds. As such, many market analysts have downgraded their outlook on the sector already. Zacks, for example, downgraded its outlook from positive in February to neutral in June on the basis of fundamental weakness in parts of the sector[3]. Though there have been improvements in housing, which can lead to higher demand for Utilities, future interest rate increases and stricter government regulation will constrain future profits. Additionally, sector capacity growth has been rising, exposing a weak demand for goods and services[4]. The five largest holdings of the Utilities sector index — NextEra Energy, Duke Energy, Dominion Resources, American Electric Power and Southern — currently have enterprise value ratios nearly 20% higher than their averages over the past decade[5]. The influx of stockholders seeking a high dividend paying stock may have unintentionally increased capital risk since, during a period of uncertainty and volatility, investors may decide to flock from the Utilities sector. The outperformance of Utilities is not supported by strong fundamentals, meaning share prices can fall violently back to Earth in the form of a mean reversion.
Investors are right to look for yield in difficult market environments, but without the right strategy and tools, they put themselves at unnecessary risk. Prioritizing yield alone, without respect to underlying quality, can leave investors exposed to dangerous market forces. Most available data on dividends is only backward looking, meaning the data does not provide a strong projection of future performance. Reality Shares developed DIVCON®, a proprietary dividend health rating model, to address these concerns. DIVCON uses a forward-looking analysis to predict future dividend growth by forecasting and ranking a company’s ability to increase or decrease their future dividends. By evaluating each firm based on seven quantitative factors, Reality Shares seeks to obtain a more accurate picture of a company’s health and better predict the probability of a change in a company’s dividend within the next 12 months. DIVCON analysis can help uncover companies and sectors of potentially low fundamental quality despite their higher yields. The Energy, Utilities and Telecom sectors, for example, all have DIVCON score averages below 3, indicating these sectors have a higher probability of cutting dividends over the next 12 months due to potentially poor underlying quality.
Markets continue to prove, time and time again, how dynamic they are, and many of the market events this year seem unprecedented. Even so, the laws of physics in corporate earnings, stock price movements and dividends cannot be broken. Investment styles and favored strategies do change over time, but in the long run, solid fundamentals and principles will always prevail. As yields become increasingly elusive in today’s market, going beyond the allure of easily attainable high yields by looking deeper into underlying fundamentals will likely prove advantageous.
Click here to learn more about DIVCON, or go to: www.realitysharesadvisors.com.
This article is commentary by an independent contributor.
Eric Ervin is President and CEO of Reality Shares, Inc. This article expresses his opinions solely and may not necessarily represent the opinions of Reality Shares. The observations and views expressed in this material may change at any time and without notice.
This material is not intended to constitute an offer, or solicitation of an offer, to purchase or sell any security or financial instruments or to participate in any investment strategy. The securities and investment strategies referenced in this material are not intended as recommendations and may not be suitable for you.
[1] Bloomberg, One of the 'Safest' Parts of the Stock Market Is Getting Really Expensive, Luke Kawa, June 2016
[2] Wall Street Journal, The Fed, Stocks and the ‘Tina’ Effect, Miriam Gottfried, Jun 9, 2016
[3] Zacks Equity Research, Industry Outlook, June 2016
[4] Charles Schwab, Sector Views, Brad Sorensen, October, 2016
[5] The Wall Street Journal, Cut the Cord on Overvalued Utilities, Spencer Jakab, September 2016
