There’s lots of evidence that dividend stocks are getting expensive. For example, this article from the Wall Street Journal (The Problem With Dividend Stocks) says that “investors have pushed up their prices so high that history says they likely aren’t worth buying anymore.” Or this one that says “Going for the highest yields may backfire.” But what’s an income-focused investor to do? Rather than simply venting about how the Fed is punishing savers with their artificially low interest rates (they are), we have three tips and three investment ideas that we believe are worth considering.
1. Don’t panic, don’t make silly mistakes
Wall Street loves it when volatility ticks up (like it has in the last week) because it makes it easier for them to get their hands on investors’ money. How so? Because trading volumes increase. Wall Street gets a cut on every trade. Whether it be bid ask spreads, commissions, or high speed traders front running your orders, small amounts add up fast and compound over time. This is one of the best reasons we believe in long-term investing. Simply put, trading out of fear can lead to very costly mistakes. Buying and holding is a proven strategy for long-term success.
For starters, if you are an income-focused investor that doesn’t mean you have to buy only the highest yielding investments. For example, an unusually high yield is often a signal of distress. Since dividend yield is simply dividend divided by price, the highest yielders are often the ones that have recently fallen the furthest, and that can signal more declines (or perhaps a dividend cut) ahead. We prefer a total returns approach whereby investors meet some of their income needs through dividends, but some is generated selling stocks that have appreciated in value. Capital appreciation can be every bit as viable as dividends in generated much needed income. Plus, it allows for a more diversified strategy which can help reduce risk (i.e. you can buy quality stocks that don’t have enormous yields). Also, don’t lose sight of your long-term goals. Even in our current low interest rate environment, it may make perfect sense to own high quality bonds or low risk cash instruments (that allow you to sleep at night) instead of owning riskier stocks, if you are able to generate enough income to meet your needs.
3. Make Smart Investments
This means own great companies, don’t be afraid to own ETFs, and make allocations to unloved asset classes. For example, consider the iShares Small Cap Value ETF (IWN), Gilead Sciences (GILD) and Wells Fargo (WFC):
iShares Small Cap Value ETF (IWN)
We believe small cap value stocks are “unloved” and the iShares Small Cap Value ETF offers a low-cost well-diversified way to invest in them. You might be thinking wait… small cap value stocks have outperformed the S&P 500 this year by more than 5% (and they have). However, they’ve underperformed by 14% since 2014 as the Fed continued to maintain artificially low interest rates which act to artificially bolster growth stocks by providing easy money to their often aggressive and risky businesses. But with the Fed starting to gradually increase interest rates, growth stocks day in the sun may begin to fade and value stocks may resume their well-documented long-term record of outperformance as shown in the following chart.
Small cap value stocks may outperform other asset classes over the long-term because they trade at relatively inexpensive prices and they are often underfollowed by many analysts (i.e. they don’t get a lot of attention). Also worth noting, small cap value has declined 4.4% over the last week (the S&P 500 has declined by 2.7%).
Gilead Sciences (GILD)
We first wrote about Gilead back on May 28th, and the stock has become even more “unloved” since then. Gilead beat expectations in their July earnings announcement, but the company fell slightly below revenue expectations, and revenues were $400 million lower than the same quarter in 2015. Additionally, Gilead announced FY2016 revenue guidance of $29.5-30.5 billion, versus prior guidance of $30.0-31.0 billion and the consensus of $31.05 billion.
The challenge for Gilead is that a large portion of its revenues are tied to HIV and HCP drugs, and competition is creeping in. Further, if Gilead fails to commercialize new products (or expand indications for existing ones) future revenues will be significantly challenged.
However, we continue to believe Gilead’s profits won’t disappear overnight, and at this point the company’s extremely low valuation is hard to ignore. Especially considering their track record of generating new growth and their ability to protect existing revenues and profit margins.
Wells Fargo (WFC)
Wells Fargo is another example of a great but unloved company. We highlighted this company back in April in an article titled “Wells Fargo: Big Dividend, Attractive Valuation.” We praised Wells Fargo saying it had “a financially strong and diversified business model, and the potential for significant price appreciation.” We also argued that it had “inappropriately sold off as many investors reacted fearfully to recent news stories about interest rates, energy sector exposures, analyst ratings, and new industry regulations.”
The stock had been performing well until recent news of a $185 million fine combined with new fears that the fed won’t raise interest rates right away. However, we believe these new fears have again created an attractive entry point. Further, we appreciate the recent article by Seeking Alpha contributor Bob Ciura titled “Buy Wells Fargo And Use The Scary News Headlines To Your Advantage.” We agree with Bob’s sentiment that “it would be a mistake for investors to overreact to short-term news. Wells Fargo will be fine over the long-term,” and “Wells Fargo is highly profitable, has a clear future growth catalyst in the form of higher interest rates, and the stock is cheap with a nice 3% dividend.”
Yes, dividend investors should be worried if they have concentrated their investments in only a few high yield segments of the market instead of taking a more broadly diversified total returns investment approach. Remember that when volatility increases and markets get choppy: don’t panic, stay diversified, and continue to own smart long-term investments.