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[Opinion] The death of high dividend equity as we know it ?

 Luc Plouvier, Portfolio Manager Kempen High Dividend Equity 

Over the past months large parts of the high dividend universe sold off on the back of higher US treasury yields as investors started to worry about the interest rate sensitivity of high dividend stocks. The benefits of high dividend stocks may nevertheless be more important than ever.

High dividend stocks have been a popular investment theme in the last couple of years. In the low interest rate environment, high dividend yield seemed an attractive alternative source of direct income. The spread between the dividend yield and the yield on debt instruments was an important measure for the bulls on these stocks. Recently this spread has decreased fast. With 10-year treasury yields potentially increasing further in the future, could this be the end of the high dividend stocks investment case?

High dividend stocks have multiple benefits, which hold irrespective of the level of interest rates. The first is cash generation. To pay a cash dividend, a company needs real cash and has to turn accounting profits into operating cash flow. As obvious as this may sound, many companies fail to do so.  Another benefit is strong capital discipline, forced by dividend payments. The recurring cash outflow from dividend is a firm commitment to shareholders. Having less cash at hand, management will think twice how to spend it. This also leaves less room for pet projects and empire building. Research confirms that companies that pay a higher share of their earnings in dividend also showed higher earnings growth in the years thereafter, with capital discipline as a possible reason.  

Valuation, finally, is important to determine the attractiveness of any investment. The benefit of dividends is they tend to be much more stable than earnings. With proper research on future cash generation and capital discipline, dividend yield is a straightforward valuation tool.

In the current market environment, both companies and investors are willing to take more risk and are prepared to pay for future growth. Companies might now particularly choose to forfeit cash generation for growth by giving customers easy payment terms or investing heavily in inventories in anticipation of increasing demand. They also spend more on expansion investments and acquisitions, benefiting from the very low current cost of capital. In other words, companies are letting down their guard and investors are letting them get away with it. What might seem attractive now can, however, look very different if capital availability suddenly dries up. As Mr. Buffett said:  "After all, you only find out who is swimming naked when the tide goes out.”

After the hit of the financial crisis, equity markets rose and valuations increased. Focusing on dividend yields can help avoid strongly overvalued stocks where others pay too much for the future prospects of a company. From time to time you might leave some money on the table this way. Long term performance is, however, far better protected when optimism recedes and valuations normalize. The premium paid for growth promises and prospects can change rapidly when expectations fail to materialize, whereas real cash earning power tends to be far more resilient.

What has happened this year does not point to the end of the attractiveness of high dividend investing. Rather, the opposite is true: the benefits of high dividend stocks might be more relevant than ever.

Although the higher yield on US treasuries and increasing growth expectations might drive speculative money out of high dividend stocks, this sell-off actually creates new opportunities for long term investors. Solid, disciplined companies that create tangible results may not be in vogue, they do generate superior long term investment results.

 

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