What Price to Pay for Yield?

Price is often a function of circumstances. Just ask anyone who has ever arrived at their hotel at 1:00 a.m. and paid $6 for a candy bar from the minibar.

Investors appear to be adopting a similar approach when it comes to stocks, particularly those with a healthy dividend yield. With bonds, the traditional income source, providing little actual income, investors are increasingly willing to pay a premium for any alternative. The question now is: how much is too much?

Dividend stocks, particularly those in more defensive industries, are and have been expensive for some time. This is a function of several trends: a preference for safe, stable companies, the growing popularity of minimum volatility funds and the quest for yield. The last one here should come as no surprise given central banks have anchored short-term interest rates at zero and long-term rates continue to be suppressed by massive asset-purchase programs and the generally sluggish nature of the global recovery.

One expensive example

Utility stocks provide a good illustration of this phenomenon. Historically, utilities, a regulated sector with a low return on equity (ROE), have traded at a significant discount to the broader market. Between 1995 and the financial crisis, the average price-to-earnings (P/E) ratio of the S&P 500 utilities sector was roughly 25 percent below the P/E of the broader market, as Bloomberg data indicates. However, since 2010 the utility sector has traded at less than a 10 percent average discount. There have even been brief periods during which the sector has traded at a premium.

This is difficult to explain in terms of fundamentals. Not only is the sector less profitable than the broader market, but today profitability is especially low. According to Bloomberg data, the ROE on the S&P 500 Utilities Index has fallen from nearly 10 percent last summer to roughly 6 percent today.

Instead, the rise in the relative valuation of utility companies, along with other yield plays, can largely be attributed to investors’ quest for increasingly scarce yield. The utility sector’s current yield is roughly 3.5 percent, not particularly generous by historical standards, but is about twice the level available from a 10-year Treasury bond, as data from Bloomberg shows.

This is important as the relative value of dividend plays is more and more being driven by the level of long-term rates. In recent years this relationship—yield vs. valuation—has come to dominate how many of these stocks trade. According to my analysis, since the financial crisis the yield on a 10-year U.S. Treasury note explains roughly 65 percent of the variation in the relative value of the utility sector.

Where does this leave investors?

First, when considering the valuations on yield names, it is necessary to take into account the overall yield environment. As long as yields remain near historical lows, relative valuations are likely to stay elevated relative to the pre-crisis norm.

Second, certain sectors are more reasonably priced than others. For example, many of the dividend payers in Europe currently look much cheaper than their U.S. counterparts.

Bottom line: given the expectation that yield will remain low for long, the question of what price to pay for yield will be vexing investors for some time to come.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation Fund and is a regular contributor to The Blog.

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