Re-evaluating risk/reward: Dividend yield vs. growth

by Michael Thomas, CFA, Wells Fargo Asset Management

Today we have a guest post by the Heritage Growth Equity team of Wells Capital Management.

For the past few years, investors have been in hot pursuit of high-dividend-yielding stocks in their quest for yield. As a result, valuations for these stocks have climbed much higher than their typical 20-year trading levels. However, investors who have bought up these high-dividend-yielding stocks need to understand the potential risk of investing in stocks that are trading at perhaps unsustainable levels.

Chart 1

Higher-dividend-yielding stocks have been trading at elevated valuations (based on PE ratio)

On the flip side, investors may not recognize that the run-up in high-dividend-yielding stocks also has created a potential opportunity—especially when combined with the solid fundamentals we’re seeing from faster-growing stocks. When strong investor demand causes one category of stocks to become expensive, investors often overlook fundamentally solid stocks within another category that have become attractively priced. We believe an opportunity like this may exist now for companies with strong, durable earnings growth.

Where’s the potential risk with high-dividend-yielding stocks?

Motivated at least partly by very low interest rates, many income-seeking investors have ventured outside the bond market into high-dividend-yielding stocks. This trend has been amplified by a sharp increase in the number of companies offering higher dividend yields.

Chart 2

The supply of high-dividend-yielding stocks has increased over time, and the supply of faster-growing stocks has declined

The hidden risk that investors in high-dividend stocks may face is this: As interest rates rise, probably in the near future, demand for income from stocks could weaken as income-seeking investors gravitate back toward bonds. Reduced demand, in turn, may cause an oversupply of high-dividend-yielding stocks in the marketplace, leading to lower valuations for these stocks and disappointing total returns for the people who are invested in them.

An opportunity in growth stocks?

Chart 2 also shows that the percentage of companies capable of delivering robust growth has declined over time. In the 1990s and early/mid 2000s, the percentage of companies capable of generating strong, durable growth was much higher than the levels seen over the past 3−4 years. As you’ll see in Chart 3, many of these high-growth companies also have displayed strong fundamentals: They have tended to deliver earnings that are well above analysts’ expectations (positive earnings surprises) over time, which makes them especially attractive compared with other companies.

Chart 3

High-growth companies have delivered solid earnings surprises, especially in the past several quarters

We believe that increased attention to earnings, combined with the scarcity of companies with strong growth potential, may lead to higher valuations for a number of faster-growing companies. In recent quarters, high-growth companies generally have experienced even greater success at delivering solid earnings surprises, compared with much of the past 10 years.

Chart 4 compares analysts’ expectations for future growth in earnings for higher-growth and lower-growth companies from the beginning of 1997 through September 2016. Since the spring of 2015, growth expectations generally have trended higher for higher-growth stocks, while lower-growth stocks have experienced steady declines.

Chart 4

Fundamentals for higher-growth companies have improved steadily, especially relative to other stocks (based on projected earnings growth)

Higher-growth stocks may have a bright future, given their solid growth fundamentals, attractive relative valuations, and the general scarcity of companies that are projected to generate robust growth. These companies also have enjoyed generally improving expectations for earnings growth. Many investors may have overlooked companies like these, however, in the midst of a focus on yield. We believe it’s imperative that investors understand and re-evaluate risks that could be hidden in their portfolios in order to lessen the possibility of serious problems down the road.

Looking for high-growth companies…

It’s also important for investors to recognize areas of the market where they may have opportunities for additional exposure in their portfolios. One of those areas may be faster-growing stocks. The good news is that there are innovative growth companies in a variety of sectors that investors could consider should they want to address this gap. These companies tend to possess powerful growth drivers that could lead to sustained growth in a range of market environments. The key is vetting companies in this space to find those with the ability to gain market share and drive strong earnings growth without over-relying on cyclical turns in the economy. Here are two examples:

  • Within the IT sector, an industry-leading company in machine-data technology offers a software solution for analytics and security. This company, a consistent performer, has delivered annual revenue growth above 45% for the past three years.
  • Within the health care sector, a company that serves clients in the global life sciences industry simplifies content management through its cloud-based platform and suite of applications designed to streamline the flow of documents across regions and departments. In our view, the company potentially could deliver annual top-line growth of 20% or more, with consistent margin expansion, over the next several years.

In today’s environment of rather limited economic growth, longer-term investors may be well served by allocating a portion of their portfolios to companies with the potential to deliver attractive, sustainable earnings growth. Investors who are considering adding exposure to this asset class should consult with their investment professionals.


Copyright © Wells Fargo Asset Management

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