29 Jun

High Rates Mean Better Valuations for Dividend Stocks

WRITTEN BY Russ Koesterich, CFA FEATURED IN Macroeconomic Analysis

Better valuations for dividend stocks

In their search for yield, investors have bid up dividend stocks to unprecedented levels. For example, in January the US utility sector was trading at a 5 percent premium to the broader market. Prior to 2009, utility companies typically traded at a 25 percent discount. That discount reflected the regulated, slower growth characteristics of the industry. The newfound premium (since reduced), on the other hand, is the result of investors seeking investments that can offer lower volatility and higher yield. In an environment of low rates, that yield becomes even more valuable. However, as rates begin to normalize, valuations on utility stocks, as well as other dividend-paying sectors, are likely to come down—a process already well underway. This should create a better entry point and value proposition for long-term investors.

High Rates Mean Better Valuations for Dividend Stocks

Market Realist – Valuations in the utility sector are beginning to look good, but watch out!

The graph above shows the S&P 500 Utility Index’s discount or premium over the S&P 500 (SPY)(IVV) earnings ratio.

Over the last few years, the utilities sector has been richly valued relative to the S&P 500. Historically, the S&P 500 has traded at a stiff discount over the utilities sector (IDU). However, due to extremely low yields on traditional steady income-giving assets like Treasuries (IEF), yield-hungry investors have been looking elsewhere for yield, including dividend-paying sectors like utilities that drove their valuations higher. Currently, the utilities sector provides a dividend yield of ~3.8%—compared to ~1.9% of the S&P 500.

This quest for yield led to lofty valuations in the utility sector. It traded at a premium of ~5% in January. However, the prospects of higher interest rates led to a correction in utilities. The Utilities Select Sector SPDR ETF (XLU) has fallen by 11.4% YTD (year-to-date). Meanwhile, the S&P 500 has returned ~2.5% YTD. This has restored some value in the utilities sector.

Higher interest rates pose a challenge to the sector. Since the utility sector requires a lot of capital, these companies require a lot of capital and usually have a lot of debt. Higher interest rates mean that these companies have to spend more to service debt. This squeezes their margins.

The financial (IYF) and technology (IYW) sectors look attractive and are poised to pay higher dividends.

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