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Reach for yield bids up dividend stocks

Investors who sought dividend-paying stocks to replace low-yielding bonds in their portfolios may be in for a surprise as interest rates rise, Steve Giles says.

Joel Dresang: Steve, in 2016 we’ve seen a rise in the popularity of dividend-paying stocks. Let’s talk about what that means for investors. But first of all, what’s been happening?

Steve: Well, Joel, in such a low interest rate environment, a lot of investors have been looking for yield elsewhere. And they’ve been reaching for that yield in popular dividend-paying stocks that are found on the value side of the market.

Joel: What has that popularity then done to the prices of dividend-paying stocks, especially compared to historical valuations?

Steve: Well, what we’re seeing on the value side of the market is a run-up in prices that’s driving P/Es to levels that we usually don’t see at this time in the business cycle.

Value stocks, by definition, have a lower multiple than the market average. Growth stocks, by definition, have a higher multiple than the market average.

So, with the value stocks being popular because they pay dividends, investors have driven up the multiples of those value stocks, and they now look pretty expensive relative to their historical norms.

Joel:  And so, investors were reaching for yield with these stocks. At the same time, we’ve been watching interest rates rise, and there are expectations of the Fed raising interest rates even further. What does that mean?

Steve: Well, Joel, it’s important to keep in mind that as you see other interest rate vehicles go up, it creates some headwinds for those stocks that pay dividends. Why, as an investor, are you willing to put up with the day-to-day fluctuation in the market owning that dividend-paying stock, when you can find the same yield or something just as attractive in a less-volatile fixed-income offering?

Joel:  And what do we know about the business cycle, and what difference does that make in all this?

Steve: We’re at the point in the business cycle, as we enter into the more mature phases of a recovery, where growth typically outperforms value, and that hasn’t been the case this year.

It’s important for us to remember that as yields rise in the fixed-income arena, it’s going to create pressure on those dividend-paying value stocks.

As we continue into the more mature phases of the recovery, you’re going to see more investors be willing to pay up for growth, and as growth takes the baton from value, it’s going to create some pressure on an asset class that we think is already priced a little bit high.

Joel:  What’s the takeaway then for investors?

Steve: Make sure that you don’t use dividend-paying stocks as a substitute for fixed income.

Yes, dividend-paying stocks do play a role in your portfolio. It’s important to have value. Keep in mind that value stocks are the most conservative area of the market. Value stocks are important for that dividend. Value stocks are also important because they provide some lower valuations with respect to the growth stocks.

Longer term, growth stocks are important because they give us much-needed upside and appreciation, but we can’t discount the role that fixed income plays.

Fixed income – yes, yield has been very low, but as it increases, you’re going to find more and more investors attracted to higher yields outside of dividend payers. And having a balance and maintaining a good exposure between your stocks and your bonds is critical longer term.

Steve Giles is vice president and investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Jason Scuglik and Peter May

(initially posted Dec. 30, 2016)

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