Global share markets today are becoming bit unhinged in the same way that they did in the late 1990s. The evidence for this is mounting up in the form of sky-high valuations for loss-making businesses and new issues where investors clamour for stock that they believe is overvalued but which they expect to go up in value all the same.
Your children call it FOMO – fear of missing out. It’s why they go to parties they expect to be boring. It’s less risky than not going and hearing later how great it was.
How this plays out in the stock market is an unseemly rush to invest in “in-crowd” type companies like AO World while shunning boring old businesses in what, 15 years ago during the TMT boom, we used to call the “old economy”.
In this context, a well-timed piece of research comes from Graham Secker at Morgan Stanley in which he points out that one of the best guides to share-price outperformance is dividend growth. Dividing the market into fifths, he shows that the companies that grow their dividends most quickly tend to outperform and vice versa.
Similar research in the 1990s by US investor David Dreman showed that the absolute level of dividend yield, not just the growth in the payout, works in the same way. In other words, over time high-quality dull stocks that pay a growing income do better than exciting cutting-edge businesses that don’t.
The numbers are striking. The fifth of companies with the fastest growth in dividends between 1997 and 2012 produced an average annual share price performance of around 15 per cent while the fifth of companies with the lowest dividend growth rate fell by nearly 10 per cent a year.
It works over the short term as well as the long haul. Over the past three months there has been a very pronounced correlation between dividend growth and share-price performance.
Now the good news is that dividends are growing fast by historical standards, according to Morgan Stanley’s research.
Of course, there is a limit to how fast dividends can grow. It is determined by two things: how fast the earnings out of which they are paid grow; and the proportion of those earnings that dividends represent.
Until recently companies were paying out a historically low proportion of their earnings as dividends – two years ago it was about 38per cent of earnings for many global stocks. This has grown because dividends have risen more rapidly than earnings but, at around 45 per cent, the ratio is still not a constraint on further dividend growth.
The lesson from 15 years ago is that in the early stage of an irrational market phase it pays to go with the flow and follow the money. At the moment, new-economy stories and old-economy dividend growers are performing well but at some point I predict that old-economy fundamentals will matter more. This is when engaging the brain will quite literally pay dividends.
As history shows, you want your portfolio to be in place well ahead of the change of sentiment, so don’t let fear of missing out on the tech stocks lead you to abandoning the income payers that will protect you when the market is more discerning than it is today.
