I recently helped a new institutional client rebalance its portfolio away from a heavy concentration in telecommunication, energy, and utility stocks. This client has ongoing income needs, and the rationale for owning telecom, energy, and utilities is of course to meet these needs with dividends. In the present market environment, however, we are wary of giving too much sway to the absolute dividend yield payed by a stock. Historically, it has been reasonable for conservative, income-oriented investors to concentrate their investments in the aforementioned dividend-paying sectors. With six-odd years of zero interest rates, however, the present market environment is novel, and we think that this requires taking a somewhat modified approach.
Since the financial crisis the central banks of the world’s developed economies have artificially suppressed interest rates by massive bond-buying programs and thereby forced investors to “reach for yield” in riskier assets. Any investment that pays meaningful interest or dividends has consequently been bid up by investors who are desperate to replace the income that they used to get from savings accounts, money market funds, and investment-grade bonds. The effect of this worldwide “search for yield” can be seen in the chart below, which compares the steady rise in prices for dividend-paying utility stocks since the financial crisis (the blue line), even as earnings per share of those same companies have stayed flat (the orange line) at around $2.77 per share.
In 2009-2010 utilities were yielding in the neighborhood of 4.5-5.0% on earnings per share of around $2.6-7. By the start of 2015 that yield had been cut in half, even as earnings had increased by less than a tenth. As a result, utility stocks are expensive relative to their historic prices and this high valuation means that they are also riskier than usual. Low interest rates and high stock valuations have also spurred a lot of mergers and acquisitions in the industry, which arguably has begun to overheat. (For example, Duke Energy recently purchased the natural gas utility Piedmont at about double its estimated fair value, “almost to the chokepoint,” in the words of Morningstar’s analyst.)
In contrast to utilities, other sectors of the market have grown their earnings in tandem with the share price increases since the financial crisis. In particular, the technology sector is noteworthy because its earnings growth has been matched by a broader maturation in many companies, which have transitioned from high-flying growth to dividend-paying stability.
As you can see from the chart above, earnings growth in the technology sector has kept pace with increased valuations. Currently at O’Brien Greene we like mature tech companies such as Cisco Systems (CSCO, $27.43), which sells computer network services and cyber security solutions to companies and governments around the world. As I write Cisco has a dividend yield of 3.08% and trades at a price-to-earnings ratio of 14.1, which is a significant discount to the broader market (the S&P 500 Index has a price-to-earnings ratio of 17.8). Most important, perhaps, is Cisco’s commitment to growing its dividend: over the past five years its dividend yield has an annualized growth of 40.9% and the company generates enough cash to sustain this growth going forward. In fact, Cisco’s cash pile is enormous. The Wall Street Journal recently identified 11 companies with cash reserves that are double their annual revenue, with Cisco (and Oracle Corp.) at the top. Cisco’s $60 billion stockpile is 1.2 times the company’s sales, and in addition to serving as a source for dividends and stock buybacks, the cash reserve can function as a shock-absorber in a market downturn and fund strategic acquisitions.
Cisco provides a nice example of how conservative, income-oriented investors can find attractive value outside of the traditional dividend-paying sectors. By giving up a little in absolute yield right now, you can find less expensive stocks that have considerably better prospects for long-term dividend and earnings growth. Furthermore, the lower valuation of stocks like Cisco should provide a greater cushion in the event of a correction, because expensive stocks typically sell-off first and fall the farthest.