Tiptoeing back into equities
There are growing signs individual investors may be ending their five-year hiatus from stocks; net inflows into stock funds were on pace to hit a nine-year high through February. For advisors whose clients are asking about potential opportunities in equities, a conversation about dividend, value and global stocks may be one worth having. Here’s why.
Dividends for all seasons
The dividend story may not be sexy, but history suggests a strategy of investing in high-dividend-paying stocks pays (pardon us) dividends. Because they provide income regardless of the market environment, dividend-paying stocks tend to outperform the broader market over time while also providing potential lower downside risk (see Chart 1). From Jan. 1, 1993, through Dec. 31, 2012, a high-dividend equity strategy generated an average annualized total return of 10.81%—259 basis points, or 32% higher, than the 8.22% annualized return realized by the S&P 500. At the same time risk, as measured by the standard deviation, was only 27 basis points higher, easily putting the risk-reward tradeoff in the dividend investor’s favor. Further, dividend reinvestment can potentially help mitigate market downdrafts by lowering the average cost of shares purchased through the reinvested dividends.
The dividend story also works well on both ends of the investing cycle—young people just starting to save and older investors nearing retirement. Studies suggest many younger investors have been avoiding equities because, after watching the market go nowhere for a decade, they view stocks as nothing more than a casino. For this group, the aforementioned traits may make dividend stocks an attractive entry point into equities. But there’s a positive longerterm reason, as well. As Federated Senior Portfolio Manager Daniel Peris has observed, the “hot stocks’’ and other growth vehicles foisted onto young people in past years have failed to keep pace with grandma and her dividend stocks. A good example is the S&P 500 Utilities Index, a standard gauge for dividend-stock performance. On an annualized basis, it has outperformed the return of S&P’s Information Technology sector index by an average 60 basis points since 1978—a significant differential—with nearly half the volatility (see Chart 2).
For baby boomers near or just entering retirement—and there are more than 76 million in this cohort—dividends offer a different sort of comfort. As concerns mount over Social Security and traditional pensions, and with the historically low interest-rate environment offering little in the way of investment-income alternatives, dividends can represent a relatively stable source of income. The parents of baby boomers already understand this—current retirees receive about half of all dividend income earned. Moreover, the tax-law changes adopted as part of the fiscal cliff compromise struck at the turn of this year arguably enhanced dividends’ attractiveness. At 20%, the new law not only held rates on dividend income well below marginal rates, it also kept them on par with the rate on capital gains.
Value in value
In key ways, a value approach to investing in equities is similar to that of a high dividend strategy—academic research (particularly work done by University of Chicago economist Eugene Fama and Dartmouth College finance professor Kenneth R. French) shows that, over time, value stocks have systematically outperformed market averages (see Chart 3). According to financial advisor and Seattle investment manager Paul Merriman, over the past 82 years, value stocks have outperformed growth stocks (so called because their earnings are projected to grow faster than market returns) 82% of the time in each five-year period. In 10-year periods, the outperformance rises to 89%; for 20-year periods, it’s 100%. At the same time, because value stocks by definition are out-of-favor stocks, they also trade at a discount to the market, thus offering the potential for lower downside risk. That’s not to suggest value stocks are without risk: they are out of favor for a reason and can lose more value. But the counter is the risk-reward trade-off: value stocks also have the potential for above average returns.
The previously cited studies shows that when stocks are ranked by traditional measures of value—price-to-earnings (P/E), price-to-book value (P/BV), price-to-cash flow (P/CF) and price-to-sales (P/S) ratios—the stock price performance of the cheapest decile or quintile beats the average of all the stocks and also outperforms each of the more expensive deciles or quintiles in the rankings. In his textbook “Investment Management,” Robert Hagin analyzed stock behavior over the 25 years ending March 2002 and found that the performance advantage for low-valuation stocks over high-valuation growth stocks was significant: the lowest P/E quintile outperformed the highest P/E quintile by 10.5% annually. In other words, the value strategy if properly used offers long-term investors the potential for above-average returns by purchasing stocks at below-average prices.
Even with the market’s run-up from its March 2009 lows, which has pushed the S&P 500 and the Dow Jones Industrial Average near their all-time highs and the Nasdaq to a 12-year high, it could be argued this still is a value-oriented market. As of early February, Federated Clover Portfolio Manager Matthew Kaufler noted, the P/E ratio for large-capitalization value stocks was about 11.8 times earnings, versus a long-run average market P/E of about 14 times, indicating value stocks are trading at significant discount to the broader market. If value stocks were just to revert to the market’s historical norm, he says, it would represent an 18% return, and that doesn’t account for potential sales and earnings growth and underlying fundamentals that could drive valuations higher if the global economy is indeed on the verge of a prolonged uptrend.
The 21st-century world
Unlike dividend and value stocks, the case for international exposure isn’t about income and the potential for lower downside risk—it’s about 21st-century realities. Almost half of the S&P 500 companies now generate more than half their profits outside of the United States, and those international opportunities are projected to increase. The United Nations estimates the ranks of the global middle class will have almost doubled from 2000 through 2025, the vast bulk of that growth coming in developing countries such as China, India and Brazil. Moreover, China already is the world’s largest manufacturer, second-largest economy and on a path to potentially surpass U.S. gross domestic product (GDP) by 2020. India’s GDP has moved past Japan to No. 3 and is projected to move past China by mid-century. And the European Union, with its common currency and coordinated policies, is the world’s largest single economic bloc.
Not surprisingly, global economic growth is projected to continue to be faster outside of the United States for the foreseeable future. Five-year projections by Consensus Economics put real annual GDP growth in the United States at 2.5% versus 3.2% elsewhere. This nearly 30% growth differential includes the slower-growing and maturing economies of Europe and Japan. Exclude them, and the differential grows substantially wider. This gap is significant for investors because economic growth is a fundamental driver of corporate earnings growth. Take South Korea, whose economic growth is expected to significantly outstrip that of the United States in coming years. Forward earnings-per-share growth for companies in that country is projected to jump 20% for 2013, nearly doubling that for the S&P 500. P/E multiples also suggest many global stocks remain a bargain, with the multiple for the MSCI All Country World-Ex U.S. Index at 12, well below its historical mean of 17.
To be sure, international investing—particularly in emerging markets—historically has carried more political and currency risks. But over the past decade, many developing countries held up better and emerged faster and stronger from the global recession than many developed countries. Their growth rates were substantially faster; their public debt-to-GDP levels were and remain significantly lower than in developed countries; and their returns, both in equities and fixed income, were significantly higher than the United States and other developed countries (see Charts 4 & 5). What does this mean for long-term diversified investors? It means it no longer should be a question of why invest internationally, but why not? A portfolio of stocks and bonds that doesn’t include foreign representation effectively is shutting the door on meaningful participation in the 21st-century economy.
Time to talk
Some have dismissed the robust influx into equity funds early this year as nothing more than long-term investors re-entering the market after cashing in their dividends and capital gains before year-end 2012 to avoid a potential tax spike—an increase that never came as a result of the fiscal-cliff compromise. They note flows into bond funds were even stronger during the year’s first month. But even if equity inflows slow, polls by various Wall Street researchers show retail investor interest in stocks on the rise. And virtually every study shows investors of all ages should include stocks as part of an appropriately diversified portfolio. So what if the investor inflows into equities prove fleeting? The conversation about why to be in them shouldn’t be.
- After a prolonged hiatus brought on by the dot.com collapse and global financial crisis, sentiment surveys and equity fund flows suggest individual investors may be cautiously returning to stocks. Dividend, value and international stocks offer the potential to ease their return.
- Dividend stocks historically have tended to outperform the broader market over time, a possible consideration for younger investors entering the equity markets for the first time. They also generally provide income regardless of market conditions, a characteristic older investors may appreciate.
- Studies show value stocks also have outperformed growth stocks and the broader market over time. At the same time, their out-of-favor status means value stocks typically are purchased at a discount to their long-term price trends, which can help to potentially limit—but in no way prevent—losses.
- Long-term investors seeking to participate in the new millennium’s economy
shouldn’t ignore the trends. Emerging markets now represent half of global GDP, and global economic growth is projected to continue to be faster outside of the United States for the foreseeable future, with the fastest growth expected to occur in newly developed and emerging countries such as South Korea, China and Brazil.