I’ve been arguing in favor of business investing through the stock market for decades now. The underlying principal is that distributable and distributed cashflows are the tangible manifestation of a successful business, especially in the most common instance where we do not have a controlling packet of the company. Most stock market investors are not Warren Buffett; instead, they are minority shareholders in an enterprise controlled by others. In that circumstance, investors should expect cash on the barrel, as one might in any other successful business endeavor such as real estate or a privately held enterprise. Obviously, start-ups, early-stage companies, and companies in distress are not expected to make payments to companies owners, whether they are publicly traded or not. That is not reasonable. But for the rest—basically for any business that is making a steady buck—the owners, particularly the minority owners, can and should expect a check in the mail. It’s not exceptional or rocket science; it’s business.
Just not in the US stock market. For reasons that I have written about elsewhere, this logic no longer holds in the magical land of Wall Street. Indeed the opposite is true. For many investors and CEOs, dividends are a sign of failure. They want nothing to do with them. The general preference is for stocks without dividends or dividends so minimal that they don’t really count. In the latter case, a miniscule dividend helps to satisfy some outdated index rule or the requirement of an equally antiquated direct benefit pension fund. But the goal of investors and managers of these companies is still focused solely on the market price—getting it up—rather than total return, the combination of distributions and their increase over time reflected also in a rising asset value or share price.
This state of affairs has left dividend-focused stock investing essentially as a boutique approach, a special situation, a subset of a particular so-called style-box, an example of factor investing with one old and not particularly interesting factor, etc. Not everyone on Wall Street is so derisive of dividend investing, but most are. This circumstance is new—it developed over the past four decades—and would utterly shock Ben Graham and any other successful businessperson or investor from the past, but that’s the way it is.
The dividend investor can’t really change that, at least overnight, so they—and I mean we—have to deal with it. And that’s the point of this post: “dealing with it” head on. The main challenge comes down to understanding the opportunity set limitation. It has not escaped the attention of many dividend-focused investors that their approach leaves a lot of stocks verboten, out of the opportunity set. That is true. Let’s admit that up front, provide the details, and then suggest how to respond to the universe limitation that results from wanting cash compensation for our cash investments.
I start with the S&P 500 Index of companies as a base. The Wilshire 5000 is broadest measure of stock market opportunity, but many of the companies there are just too small and illiquid for practical investment. The Russell 1000 index is another potential starting point, but for simplicity’s sake, we’ll use the market’s main large cap index, the S&P 500 Index. By that measure, the US stock market has a remarkably low cash yield. It’s non-sensical from a cash investment or business investment perspective, but such nonsense has been tolerated for years by investors and company executives alike. As of 6/30/21, the indicated S&P 500 yield was 1.35%. The median yield is almost exactly the same at 1.34%. We are in the territory of false precision here due to the many ways yield can be calculated. We can just acknowledge that it is exceptionally low, lower than it has been since the modern US stock market started in the early 19th century other than at the very peak of the tech bubble in March 2000. At that time, the market hit a trailing 12m yield of 1.1%. So we are not that far away.
Why the US stock market has such a low cash yield is a topic for another day, and for many other posts on this website. To summarize, it is a reflection of interest rates, the share buyback phenomenon, and a hurly-burly investment culture that has been characteristic of the US stock market the past several decades.
The number is just crazy low, and might discourage some investors from thinking that they can use the US stock market as a traditional business ownership platform. That conclusion would be wrong. That’s because the aggregate number is somewhat misleading. It varies materially by sector. You can see that in this summary table. If you dig deeper, you will note that it varies materially within sectors as well.
|Sector||% SP50 (market cap)||n-count||median yield||average yield||weighted yield|
|Source: Bloomberg LP, & Federated Hermes, Inc, 2021, as of 6/30/21|
|Note: The 5 entities with dual class structures do not not affect aggregate yield calcs.|
Let’s review. The median and average yields are below 1% for Communication Services, Consumer Discretionary, and InfoTech—it goes without saying. Those three sectors represent 51% of the stock market combined. There’s no there there. They are 163 companies, about a third of the numerical opportunity.
At the other end of the spectrum, the small Energy sector has a 4% yield, distorted by the big yields and sizes of the two large IOCs included there. And utilities come in with a 3.2% yield. Nice, but let’s keep in mind that those two sectors constitute 5.3% of the market’s capitalization. There are only 50 companies in those two sectors, out of 500. So only 10% of the market has a weighted yield of 3% or better.
So lesson two, the dividend-focused investor needs to be—has to be—highly selective. And it’s not just about sector choice. Particularly after a recent reconstitution of the index, it can be tricky even within sectors. Communication services has both ATT & Verizon—both big sources of income—as well as Google, Facebook, Twitter, Netflix—pillars of the new economy which pay zip, as well as two more traditional companies, Charter and T-Mobile, which can’t be bothered to pay a dividend. Out of top 10 largest companies in the sector, only 3 pay a dividend. You can find similar stories in other sectors. While they may be lumped in the same broad sectors, companies can have very different policies when it comes to rewarding the shareholder.
Some of those policies leave no room for judgment. 120 of the S&P 500 have no dividend at all. There’s not much analysis needed there. At the other end of the spectrum, 85 companies have a yield of 3% or better. That’s plenty to anchor a portfolio, but you get the picture: this is an uneven balance.
And here’s the point of this exercise. You have to make choices. To get cash from your investment, you have to give up something. Those 85 companies they represent just 11.5% of the index. On the positive side of the ledger, 10 out of the 11 S&P sectors are represented. (One Industrial—the maker of Post Its and facemasks just misses the cut). And they offer a broad variety of goods and services If you expand the group to a 2.5% yield threshold, it becomes 126 names, and you get a handful more industrials. So you can easily build a well-diversified portfolio of leading business and get paid in cash for it as well. (Layer in another 30-50 or so dividend-friendly foreign corporations which have liquid shares trading in the US, and the opportunity set becomes quite ample.)
The challenge for dividend-focused equity investors is to realize that while they have a well-diversified portfolio of the US stock market, it is not the same as market completeness. Despite easy access to 10 if not all 11 sectors, the dividend investor needs to make peace with what is not included. Those 120 companies in the S&P without any dividends also include a lot of brand names and dynamic business models. The FANGs of course, and Tesla, are in that group. Big pharma is available for investment, but biotech is not, with the exception one or two of the more mature large-molecule companies. Phone companies yes; social media no. Only a handful of consumer discretionary names get close, but that is probably a good thing. They are not popular with dividend investors for good reason. Of the 120 companies without dividends, fully 86 come from Info Tech, Consumer Discretionary and Healthcare. For investors who want to “play” those stocks, they need to do it elsewhere.
In short, there is plenty of opportunity to create a diversified, dividend-focused portfolio from the US stock market, but it would be a mistake to confuse such a portfolio with the market portfolio. Forty years ago, yes. A century ago, yes, but not now. Fortunately, most intermediaries I speak with are well aware of this and understand the opportunities and limitations of investing for dividends in the US market. They get their “stock” exposure elsewhere. That’s all for the bad news. And it’s really not bad news. It’s just being aware that a dividend-focused portfolio should not be confused with a complete-market approach.
Now on to the good news. First, the bad news is the good news. This crazy non-businesslike nature of the US market is simply not sustainable. At some point it will mean revert, minority business owners will want their cash. At that point, dividend-focused equities will see greater favor and the n-counts discussed above will shift move dramatically to the right, towards more companies having larger payouts. An anomaly can only go on only so long, and 30 years is quite long enough.
But in the meantime, there are consolations for the dividend investor. Being a boutique style means that it is not crowded. There are robust income opportunities hiding in plain sight, overlooked by the stock-price only crowd. They may not involve social media or gene editing businesses, but it is quite possible to put together a basket of them and benefit from a high-and-rising income stream.
Finally, one straightforward way to attend to the opportunity set limitation is to rethink asset allocation. In the traditional asset-type/asset-price driven model, income is an afterthought. But if you consider assets from their income generating potential—regardless of their nominal asset class position—new opportunities emerge. This means building a portfolio out of a variety of income generating assets—equities, fixed income, real estate, private enterprises—and managing the portfolio from an income perspective, not the daily price changes of the publicly traded assets. In that exercise, all the non-income producing assets—the non-dividend stocks, the start-up ventures, the distressed businesses—are siloed together as a special “play allocation” and are understood to be price only ventures. There’s nothing wrong with a bit of excitement in one’s portfolio….
This cash-based approach to asset allocation is taken up in greater detail in Getting Back to Business from 2018 as well as in the current project I am working on. Stay tuned. In the meantime, keep clipping those coupons. It turns out that being a long-distance runner can be a very satisfying and very successful endeavor. Slow and steady wins the race, in the markets as in life.
July 17, 2021