Wednesday, January 17, 2007

Dividends Over All

For most of the last twelve months, our mantra, as it related to stocks, has been: big over small, value over growth, and dividends overall. The relative performance of the sectors has waxed and waned during the year, but, for the most part, our mantra was correct.

In looking at the data recently, however, we were very surprised just how much of a "dividend" year it was. Breaking the S&P 500 into quintiles from highest dividend yields to lowest, we see the following total rates of return:

The table shows that stocks of all styles and sizes enjoyed solid double-digit returns, but the top 100 highest yielding stocks had a total return of nearly 20%.

I have not seen much discussion of this phenomenon. In fact, I am a dividend watcher, and I was not aware of just how strong high-yielding stocks were during 2006 until I was doing some attribution work and noticed it.

The first thought that came to my mind was--why? What was it about 2006 that gave such a lift to high dividend yields? Had interest rates fallen? No, in fact they had risen. Had there been a flight to safety? No, I would have say there was a move back to quality, but not an outright flight to safety.

In the top 100 yielding stocks in the S&P 500, there are an abundance of REITs, Banks, Utilities, and Energy stocks. Of the four sectors, energy stocks having a good year is easiest to explain. REITs had real estate worries, Banks had Fed rate hike and real estate worries, and Utilities had runaway energy cost worries. Yet all three of these sectors outperformed the energy stocks and the major indices.

What story or scenario could push all of these sectors higher in the face of rising interest rates? Certainly, one answer would be slow growth. All these sectors tend to do well in slow growth environments because their earnings are relatively stable. But 2006 was a hot earnings growth year and GDP was above the trend of the last 80 years. Under these circumstances, I would have thought that performance would have been best among the big earnings growers like the consumer staples, capital goods, techs, and basic materials, not the more defensive sectors.

I am not sure, at this point, that I have an answer that really suits me, but the one that makes the most sense was that investors decided that if $75 a barrel oil could not push long-term interest rates above 5.0%, then nothing would. And if inflation and interest rates were destined to be tame, REITS, Utilities, and Banks all deserved to sell at lower dividend yields. Energy stocks rose in the old fashion way-- their huge earnings pushed them higher.

One last point on attribution work. I noticed that earnings growth in almost every sector was greater than price growth. That leads me to believe that growth stocks have some catching up to do. More on that later.