It has been a good year for the S&P US Dividend Aristocrats strategy, but that success is making some anxious about 2014.
The index, composed of US large caps that have increased their dividends annually for at least 20 consecutive years, has returned 28% over the past year. The S&P 500, in contrast, has risen by 26%.
That run has, of course, inflated valuations. The US Dividend Aristocrats trades on an average price-to-earnings ratio of 18.5 and a typical price-to-book multiple of 2.9. The equivalent figures for S&P 500 constituents are 15.9x and 2.5x.
‘Underlying valuations on aristocrat stocks have increased significantly over the past 12 months, and shorter-term, investors may well consider taking profits,’ said Jonathan Jackson, head of equities at Killik & Co.
Then there is the question of what impact the tapering of quantitative easing will have on the aristocrats, whenever it occurs next year. When Ben Bernanke first mooted the idea in May, the aristocrats index fell by 5.1% over the following month while the S&P 500 slid 3.7% as investors fled bond proxies.
And for those who view the strategy principally in income terms, rather than as a way to buy high quality blue chips, the index’s high prices have depressed its yield to 2.7% compared with 2.1% from the S&P 500.
Despite such concerns, Jackson is nevertheless willing to recommend the approach to US equities for long-term investors, especially those tempted by the higher nominal yields available in exchange for greater risk elsewhere.
‘A more sensible long-term income strategy is to focus on strong franchises that have a history of growing their earnings and dividends, even if this has to be from a lower level.’
First, Jackson deems it ‘understandable’ that progressive dividend payers with strong track records should be more expensive than other companies. The index’s composition biases it towards businesses with stable, visible revenues: its largest exposure is to consumer staples, with a 20% weighting against 10% in the S&P 500.
Equally, information technology comprises just 4% of the aristocrats index compared to 18% of the S&P 500. Second, though, Jackson challenges the notion that the aristocrats are even expensive at the moment. Valuing companies solely by their earnings ‘does not take account of the less leveraged balance sheets amongst the dividend aristocrats,’ he said.
Both the aristocrats and the S&P 500 stocks trade on an enterprise value of 9.4x their Ebitda. And the aristocrats are actually more attractive in terms of their net debt to Ebitda ratio of 1.3 compared with the S&P 500’s 1.6.
Now, the relatively lower gearing employed by the aristocrats does mean they are more likely to lag if US equities as a whole continue to rally.
Jackson is not unduly bothered by this, noting that the income growth from their progressive dividends should offset this through the long term.
Furthermore, he observes the low debt levels and defensive nature of the index have historically helped it outperform in bear phases. In 2011, for instance, the S&P 500 was flat but the aristocrats eked out a 4% gain.
Whether that pattern will hold, or May’s sell-off is the new paradigm, is uncertain.
‘The higher headline valuation on the underlying holdings may provide less downside protection in the event of a market correction and the shorter-term investor should be mindful of this,’ Jackson said. ‘However, we continue to favour the strategy for the more patient longer-term investor.’
Edward Fane, fund and research manager at Thesis, is more cautious about the aristocrats strategy. ‘There has been a cohort of companies in the US that has real longevity and consistency when it comes to paying dividends. ‘But we have never felt the US market needed to be approached in that way.’
In particular, Fane is reluctant to sacrifice growth for income, and to introduce the sector bias inherent in the aristocrats index.
For Peter Askew, senior multi-asset fund manager at T Bailey, the ability to invest in such narrow strategies is in fact an advantage.
‘We are all trying to identify where the value lies away from the wide index. It is a very broad market and people are going to want to move into more focused areas, whether that is equity income, value or growth.’