Published on January 23rd, 2018 by Nicholas Ward
The first two pieces that I published here at Sure Dividend were focused on somewhat speculative, high growth stocks, so I’m happy to get back to my conservative valuation based roots here with my third submission.
This piece will be focused on the T.I.N.A. market that we’ve all been investing in throughout the last handful of years. I’ll be taking a look at the risks and repercussions of such an environment, and how I’ve been dealing with it personally.
Many of you may not be familiar with the T.I.N.A. acronym. I’m not sure when/where/who officially coined it, but it stands for:
“There Is No Alternative”
This is referring to historically low interest rates driving income oriented investors (both retail and institutional) into equities (and therefore, higher risk) because it wasn’t possible for them to meet their minimum yield thresholds in the fixed income markets. I understand why this has been happening and in certain cases, I can hardly blame investors/portfolio managers for the increased risk that they’ve exposed themselves to, but it’s a dangerous practice, nonetheless. What’s more, it’s not only potentially dangerous for the investors out there reaching for yield, but it poses risk to the entire market as a whole potentially toppling over due to an artificially inflated shareholder base.
The U.S. bond market has been in a raging bull market since the early 1980’s when the 10-year treasury yield topped out at nearly 15%. Since then, we’ve been on a fairly steady decline with the yield bottoming out in the ~1.4% range several times during our current decade. We saw an uptick of rates during 2013 and I remember analysts saying that it was time for the bull market to end. Well, flash forward to 2014, 2015, and 2016, and we saw that those prognosticators’ estimates couldn’t have been further from the truth.
However, the FED has begun the normalization process with rate increases and plans to liquidate its balance sheet and rates are on the rise again. Murmurs of the generational bull market coming to a close are growing louder again and if they turn out to be true this time, the effects won’t be isolated to the security markets.
I’m not a professional money manager (I just manage my own), but I am friends with a handful of individuals working in the financial management industry and recently they’ve been telling me stories of historically conservative investors wanting to increase their exposure to equities today.
While this isn’t surprising because of the massive equity rally that we’ve seen over the last couple of years, it is worrisome. When the markets hit new record highs and post 20% annual gains, it’s easy to understand why some investors who were on the sidelines might feel like they were missing out. Greed typically doesn’t care much for valuations though, and exuberance is what leads towards unsustainable premiums and eventual corrections/crashes.
When the market corrects it’s usually the weak hands that end up folding. Sure, some responsible, rules based managers might strategically sell out of certain positions, locking in gains or setting up tax-time losses, but for the most part, it’s fear that rules those types of days and since both fear and greed are inspired by irrationality, it doesn’t take much for one to transform into the other.
Over at my website, I’m currently in the middle of writing a series titled, “No, The Stock Market Isn’t Rigged Against You,” in an attempt to prove to the masses who believe that the stock market is nothing more than a Wall Street Casino where the wealthy get more wealth and the Main Street investor gets swindled that their belief couldn’t be further from the truth. Please enjoy parts One and Two after you finish reading this piece, if you have the time.
I know that sometimes the market can seem unfair, but I think if we’re truly being honest with ourselves, it wasn’t Wall Streets fault that we lost money in the markets; more often than not, it was because of fear and/or greed that led to a mistake. All of the work I do with regard to asset allocation and due diligence as I monitor my individual positions is to prohibit me from the fear/greed driven pitfalls that harm so many investors.
This is also the reason that I’m writing this piece. Obviously there are too many variables in play for anyone to every know what the future has in store for them. Due diligence cannot completely protect anymore from capital loss because every investment comes with inherent risk, but sometimes it doesn’t take much time or effort to realize that something fishy is going on and certain equity should be avoided. Being forced to pay growth stock premiums for slow moving, defensive companies should have set off alarms in value based investors’ minds.
With interest rates falling to record lows in July of 2016, breaking through the 1.4% level to the downside, investors flocked into “bond equivalent” equities yielding 2.5-3.5%. In reality, there is no such thing as a “bond equivalent” equity; equities come with much more risk than bonds.
However, as DGI investors know, from a purely income oriented standpoint, it doesn’t get much more reliable than many of the consumer staples, teleco’s, utilities, and even REITs, for those wary bond investors looking for a safe place to land with a yield above their target threshold. This influx of new money into equities, and especially into the ones that we all know and love as DGI investors, pushed many valuations into the overvalued arena (some grossly so).
Over the last 12 months or so we’ve seen sell-offs in some of these defensive areas of the market. Packaged foods, for instance, had a tough year. REITs and utilities have suffered more recently with tax reforming passing, likely resulting in a strong economy which will justify another 3-4 more rate increases in 2018.
Many of the dividend stalwarts have maintained their positions of strength, but oftentimes, this is in the face of stagnating/falling sales and earnings. Investors may have been willing to ignore many of these troublesome fundamental growth trajectories, but management teams haven’t. David Fish’s CCC list shows that dividend growth rates have fallen over recent years across the Champions, Contenders, and Challengers groups.
I have a hard time believing that the chickens won’t come to roost with regard to these eroding fundamentals combined with historically high premiums. Many consumer staples stocks have bounced a bit over recent months, but 2017 wasn’t a fun year for you if you held companies like Kraft Heinz (KHC), General Mills (GIS), Kellogg (K), and the like. Many companies in this space posted double digit losses in 2017 while the broader markets were up ~20%. Investors typically invest in these types of names because of their yields, their low beta, and their relative defensiveness…not to lose significant amounts of money in a strong market.
Here’s a couple of examples of multiples rising and contracting in the defensive space over the last couple of years as the T.I.N.A. market took hold. Without exception, every one of the 10 popular DGI picks that I chose to focus on here was trading at a much higher premium in mid 2016 (when yields hit historical lows) than they were in June of 2011 (when the 10-year took its most recent leg down from ~3% on the charts). Several of the stocks on this list have lost their strength, selling off to more normal premiums over the last year or so, but others remain irrationally overvalued because of the market’s thirst for yield.
As previously highlighted, the problem with this chart isn’t just the fact that premiums increased, it’s that they increased in the face of fundamental growth issues. Take a look at this graph below, highlighting 2011 EPS (or operating cash flow in the case of Realty Income) versus 2016 totals. Not a single stock on this list (which is full of high quality companies) generated a double digit bottom line CAGR over the same 5-yaer period of time when their valuation sky rocketed.
This goes to show that the gains weren’t driven by fundamentals, but instead, investor having no other alternatives in terms of yield. This is scary to me; over the long-term the stock market is driven by fundamentals, not investor sentiment, and I think these names are due for further unwind (or years of stagnation) as their fundamentals catch up with their bloated valuation premiums.
I promise that I didn’t do any cherry picking with these 10 stocks. Many if not most U.S. based Dividend Aristocrats and high quality dividend growth stocks that operate in a defensive industries fit this trend. Unfortunately, this leads me to believe that many of the DGI-type names that have been overvalued because of the T.I.N.A. market will post below average returns moving forward until their fundamentals are aligned with their pricing premiums.
And this brings us full circle to my previous two articles here at Sure Dividend. These irrationally high premiums on the low beta names with reliably increasing dividend yields that I loved to buy during the first few years of my investing career have essentially forced me into the more speculative high growth names.
You see, I haven’t been willing to play into this T.I.N.A. trend. Although I’ve oftentimes sacrificed yield and augmenting my passive income stream when buying high growth technology names, I haven’t broken the valuation based principles that serve as the foundation of my DGI approach. When companies that are posting low-mid single digit EPS CAGRs are trading with the same multiple as companies posting strong, double digit EPS CAGRs, why in the world would an investor choose to buy the former?
As much as it pains me to say it, a 3% dividend simply isn’t worth the pricing risk (especially when you factor in the likelihood that the high growth names will post significant relative outperformance, based upon fundamental growth alone).
Another positive that investors in the high growth tech names receive relative to the more traditional DGI names is the fact that they aren’t nearly as interest rate sensitive. Sure, if the 10-year reaches a yield threshold at disrupts the current market status quo, driving income oriented investors back into fixed income, equity multiples will contract market wide. Some analysts argue that this will actually effect the high premium tech names more than stocks from other industries/sectors due to a lowered risk tolerance in the market, but I don’t buy into this theory (at least, not over the long-term).
The secular growth trends that have driven the disruptive revolutions that we’ve seen in the tech space won’t end because of a 3% 10-year. Heck, they won’t end with a 5%, 6%, 10%, etc.
Secular growth, by definition, is spurred on by forces unrelated to the markets. Even if we see multiple contraction across the high growth space in the short-term, it won’t take long for their fundamental growth to make up for the slack and I suspect we’ll continue to see share prices move higher over the long-term. On the other hand, defensive, income oriented names simply don’t have this fundamental strength to fall back on.
Just remember, there is always an alternative. I’m a firm believer that even though in this day and age of exchange traded funds and algorithmic trading that move major indexes as a whole, the stock market is still just that: a market comprised of individual stocks. Over the long-term, I believe that the crème rises to the top and that generally, valuations, whether they’re cheap or expensive, will always revert to what is appropriately fair.
In a market where there are so many wonderful companies to choose from, I’ve just about always found that one or two of them are trading with attractive valuations.
And what’s more, if you can’t find a high quality company (or investment for that matter) that you like, there is no one forcing you take outsized risk. I understand that retirees have certain income thresholds that they need to meet to sustain their lifestyles, so if you fall into that boat, I can hardly blame you for trying your best to meet your passive income needs with the least amount of risk possible, but if that isn’t the boat that you fall into it’s important to remember that cash can be a very valuable asset to hold.
Sure, cash doesn’t compound like a rising stream of dividends does, but then again, it doesn’t shrink either (outside of normal inflationary forces). Holding cash likely won’t result in some of the significant capital losses that we’ve seen across several previously overvalued segments of the market. What’s more, it will give investors the opportunity to buy into weakness when the market finally come to its senses and realizes that 20x earnings multiples should be reserved for companies with strong top and bottom line growth prospects.