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Dividends & Income Digest: Once Interest Rates Rise, What Happens To Dividend Growth Stocks?
Jul. 10, 2015 7:35 PM
- Every issue, SA explores a dividend and income investing question and shares the responses, as well as highlights some of the week's insightful pieces of opinion and analysis.
- This week, contributors answer the question: "What happens to dividend stocks when interest rates go up?" And a rant about trolls.
- What should Seeking Alpha be tracking in the dividends & income world? Leave a comment to let us know. Or better yet, submit an article of your own.
This week, I bring you the second issue of Dividends & Income Digest. It's looking like I might post these every other week, given the volume of submissions (keep up the good work, everyone!) and the amount of time it takes to get responses to the questions from very wise, but very busy, contributors.
Before we dive into this week's question and the top articles of the week, I want to discuss openly and candidly something that's bugging me. Earlier in the week, Mike Nadel published an excellent piece: "So, You'll Switch To Dividend Growth Investing After You Have Your Millions, Eh? ", which essentially analyzed the feasibility of poof! pulling a switch and moving a lifetime of assets from a total return-focused portfolio to a dividend growth portfolio in retirement (Mike, I hope I got the thesis approximately right, as it was a bit more complexly articulated than that). In just two days, the article has received 736 comments at the time of this writing. That's some pretty darn incredible engagement, and it shows this was a topic that you all found valuable and important enough to discuss in depth and at great length.
However, the trolls crept in and kind of ruined the party for everyone. In fact, I noticed a few comments about my queueing up the article as a topic of "amazing discussion" and the resulting "disappointment" on their part. I even received a direct message from a particularly ornery user accusing me of being a new Seeking Alpha employee (I've been on staff for 3 years, which he would've known had he read my profile), and fostering a DGI "clique."
Look, you folks are a lot smarter than I am. You're the idea machines, the investors who are in the trenches day after day. I know for a fact that I don't know any more about dividend growth investing than any of you, and probably a heckuva lot less. And I'm new to mingling in the comments, so I'm just doing my best to, frankly, not mangle my words and make sure I say what I mean. I do like to help get the conversations going -- that's part of my job as an editor and community manager. So if there's any way I could be doing that better, please feel free to offer suggestions. I'm learning all I can, as fast as I can.
In any case, perhaps I'm overly sensitive or just new to the commenting scene, but rude, judgmental comments ruffle my feathers. I know I'm preaching to the choir here among those who are actually going to read this, but I have to say that we're all here to learn from each other and exchange ideas -- respectfully. Derogatory or useless comments just waste everyone's time, and they don't offer any value. And at the end of the day, isn't that why you come here -- to glean useful, valuable investing ideas and insights from our authors?
I know I can't single-handedly stop the trolls from saying what they will, and I'm well aware rudeness abounds on the Internet due to the ease with which anonymous users can shoot barbs from behind their keyboards. And I'm certainly not trying to take away anyone's freedom of speech or right to sound off on any darn thing they want. But if we could just try to be a little more respectful, a little more uplifting, encouraging and supportive, I think that would go a long way toward making this community an even better, more positive forum than it already is.
What Rising Interest Rates Mean For Div Stocks
Okay, I'm hopping off my soapbox now. My apologies for going on longer about this topic than was probably necessary. On to this week's question. In the comments thread of the inaugural issue of the Digest, Rick in Colorado (Rick CO ) asked:
"What will happen to Div Growth stocks in the next few years if interest rates cont. to rise? we are already seeing the effects on REITS and Utilities. will the price action spill over to the traditional DGI's such as GIS, KO, and others. will this become a great buying opportunity or value trap? If interest rates cont to rise, will the "hunt for yield" slow significantly. I think we need some more critical thinking along this theme."
It's definitely a question I've been thinking about, and I know others have, too, so I asked a handful of contributors to weigh in. Here are their responses:
The safe answer to the question is that the effect will be variable from DG stock to DG stock, contingent on the market's belief about how sensitive a respective security's operations are to higher rates, what its valuation and actual/forecast EPS/dividend growth rates are, how levered its balance sheet is, and the rapidity of interest rate movement.
There's no question that "garden variety" large-cap, as I like to call them, popular dividend growth stocks, have experienced valuation expansion since the fiscal crisis without, in many -- perhaps most cases, supportive fundamentals. But there has been a sense of rationality to valuation expansion, given the lack of reward in other asset categories. So far, pursuing yield hasn't proven particularly disastrous. However, as rates rise, valuation contraction will undoubtedly occur in C-corp stocks, especially those with slow growth characteristics. Higher cost of capital will hit bottom lines, especially those with higher leverage or shaky credit. At the same time, higher investment grade bond and cash yields will generally
attract money away from dividend equity.
Buy and hold investors, therefore, need to think long and hard about how much they are willing to pay for equities in today's market. They should also have a macroeconomic thesis to justify their decisions. Contrary to what some dividend haters like to proclaim, I don't think there's a bubble, with imminent 50% shellackings. However I do think the potential for a material, broad index correction or another "lost decade" scenario, where we don't necessarily experience a nasty sell-off, but tread water for many years, is very real. We've already seen double-digit sell-offs in some mega-cap names and rate sensitive issues, despite steady operations. This will likely intensify if the 10-year Treasury pushes towards 3 percent.
For those in need of income with plenty of cash, I would average into positions. This is clearly not a time to be making big bets or trying to play Superman. But the contrarian in me thinks that so many people have been anticipating a wholesale correction for so long that perhaps it won't play out as widely expected. So continuing to hold heavy levels of cash could be a losing proposition. Being out of the market and watching it rise year after year does not make one feel warm and fuzzy inside. But I also say that I'd rather be wrong and out of the market than wrong and in the market.
My personal view is that while long rates will continue to be volatile, I don't think the Fed is headed to the races near term like they were in 1994. Still, the bond market will move independent from the Fed. Investors should keep close tabs on the 10-year Treasury, as the higher the near-term ceiling on it is, the bigger the potential sell-off in dividend equities will be. While REITs and utilities usually get hit the most, I wouldn't be surprised to see large-cap C-corps, whose EPS and dividend growth trajectories are starting to become utility-like, get hit hard as well, especially if the Fed insinuates a need to open the tightening spigot more during the second half of the year.
While some pundits like to point to a "market of stocks" instead of a stock market, if a wholesale valuation contraction occurs, nothing can escape that. Trying to own stocks that can weather macroeconomic and rate volatility is a defensive solution, but there is generally no way to insulate totally from a market re-pricing.
Historically, the benefits of a stronger economy have compensated the impact of higher interest rates, allowing valuations to return to normalized levels. REIT investors who are aligned to take advantage of these opportunities may be rewarded over the long term. Here's a snapshot of all US REITs historical dividend growth since 2000 (source of data: NAREIT).
… We're getting closer to rate liftoff, and most investors expect interest rates to increase in 2015 but only in response to continued strengthening in macroeconomic demand conditions. An increase in interest rates is generally bad for investors only if income doesn't increase with them, but for REIT investors we typically see income increasing as occupancy levels and rent growth improve. The normal historical pattern has been for listed REIT returns to be positive when interest rates increased because of the macroeconomic strengthening happening at the same time.
I still see attractive risk-adjusted returns over the long-term for the equity REIT space. They are income vehicles, but they are designed to grow over time and could be seen as bonds with expectations for long-term growth (in price and dividends) to cover the risk premium assigned to equity securities. I frequently cover the mREIT sector. When viewed in the context of all available securities, I believe an mREIT index would offer lower expected long-term returns than equity REIT indexes. The problem for retail investors seeking diversification is compounded by a lack of competition in the area of mREIT ETFs, which encourages dramatically higher expense ratios for the mREIT ETFs relative to equity REIT ETFs. The higher expense ratios compound the problem of lower expected returns across the industry. Basically, the Vanguard REIT Index ETF (NYSEARCA:VNQ ) is significantly better than the iShares Mortgage Real Estate Capped ETF (NYSEARCA:REM ) as a very long-term (20- to 50-year) holding.
One of the reasons I put effort into covering the mREIT sector is that I believe there can be some meaningful pricing errors, especially with the smaller companies. To that end, I invest in individual mREITs and buy the major ETFs (VNQ/SCHH) for equity REITs. My allocation to equity REIT ETFs is substantially larger than my allocation to mREITs due to the benefits of diversification from a portfolio risk management perspective.
p.s. For comparison sake, I'm assuming reinvestment of dividends.
Interest rates rising is not a bad thing for dividend growth stocks at all. It means the economy is getting better and there might be some inflation, which will lead to pricing power for many of my favorite blue chips. That means more revenue, higher earnings and continued dividends. The REIT section has been oversold in my opinion based on FEAR of rising rates and only the REITs that are directly tied to mortgages would be affected most, mREITs, etc. Utilities get rate hikes and will probably be able to increase charges when inflation kicks in. A company like Consolidated Edison (NYSE:ED ) is an aristocrat and they know how to operate. Overall, when the Fed raises rates, there could be a temporary dip in ALL stocks, but over the long term history has shown that markets will rise anyway. Actually, I am looking forward to getting back to "normal" without artificially held low rates.
And finally, a bonus article from Seeking Alpha contributor Sure Dividend, who also discussed this topic over at his blog, suredividend.com .
Now it's your turn to weigh in. There seemed to be a REIT-heavy focus among the respondents. How do you think dividend stocks will be impacted by rising interest rates, and how will you change your investing strategy, if at all?
And now, on to the week's Dividends & Income news and analysis:Source: m.seekingalpha.com