Jun 2, 2022

The Ugly Truth — And Dividends Matter

Things are certainly ugly right now. And, historically, that’s when we find the markets more attractive. Looking past the Ugly and its relentless headlines—war, mass shootings, high food and gasoline prices, stock and bond market losses—is never easy. But can it be rewarding? We think so. We think valuations and dividend growth should be on “page one” and have a good chance of getting there

Valuations are now Fair and Attractive

If we assume the 500 companies Standard and Poor’s researches and selects are a good proxy for great companies, then it may well be productive to assess the valuation of today’s S&P 500.

There are oodles of ways of doing this.  Let’s look at the classic, time-tested Benjamin Graham formula for a fair market P/E multiple: 

P/E = [8.5% + 2*Earnings Growth]*(4.4/Bond yield(AAA))

The AAA corporate bond yield is 4.1%. Corporate earnings growth is expected to be in the upper single-digit range. Plugging in a low-end earning growth forecast of 5% results in a P/E multiple of 19.6. At the higher end, assuming earnings growth of 8%, the fair value for P/E multiple is 26.8. The current forward market P/E multiple is 17.6 which shows that valuation is no longer a headwind for the market.

Some analysts cite Buffet’s traditional view that a good way to see the value of equities is by comparing earnings yield to the 10-Year US Treasury.   The thinking is if earnings yield is at least 2X the current Treasury Bond yield, it is a good buy.  As the 10-Year Bond at 2.86% right now, the marker for good value would hence be set at 5.72%.  With P/E being the inverse of earnings yield,  the P/E of the S&P 500 would thus have to be 17.5 or lower to represent good value.  Again, the forward P/E of the S&P 500 is 17.6.

Companies are Flush, Dividends Could Be Lush

S&P 500 companies (excluding the “Financials” segment) are flush with excess liquidity.  In total, they are holding $1.9 trillion in cash.  In fact, there are 219 US companies above a market cap of $1 billion whereby cash represents 25% or more of their market cap (source: JPMorgan Research May 27, 2022.)  We see this “flush with cash” environment as a large driver for attractive dividend growth.  And it’s showing up in the work we do.  One need only look at the dividend pass-through levels our INNOVA High Equity Income Innovation Fund (TILDX) was able to achieve in May.  The Fund’s monthly distribution was $0.1564 per share for May.  Based on a closing NAV of $11.82 at month end, that  translates into an annualized rate of 15.9%; the highest monthly dividend income distribution rate in the Fund’s history.  While May often produces above-average dividend opportunities for the Fund, we are seeing the effects of lush corporate cash levels as a tailwind for dividends.  We think this has the potential to continue and if it does, it will be a positive for both the large S&P 500 companies component of the Fund and the companies aligned with the global dividend rotation component, which has been key to dividend income generation.  That said, the trailing twelve-month (TTM) yield of TILDX is now 7.31% (source: Morningstar.com May 31, 2022.)

If Inflation is the Game, Dividends are the Name

While we believe inflation will moderate, it very well could settle at levels that are both “digestible” to the economy and yet higher than the low 2% level we’ve seen for quite some time.  We are reminded that inflation, in and of itself, is not a bad thing for the economy.  After all, the Fed, as recently as the August 2020 Jackson Hole summit, expressed an interest in reflating the economy and combating the deflationary forces of new technologies.  Persistent, high inflationary levels would be a concern.  While we don’t believe we are on the cusp of a decade of high inflation, we note the work of analysts at Standard and Poor’s who studied the total return of the S&P 500 decade-by-decade over the past 100 years.  Dividends, as a percent of total return, were the very highest during the two decades which experienced the highest average level of inflation; the 1970’s and the 1940’s (see chart below.)

What do we think?


We think the Ugly is the now.  But we think the Ugly will pass.  Clouds will be lifted.  And investor demand for stocks will rise along with earnings and dividends.

We think the most likely next phase is one where growth is more evident, versus the Ugly getting uglier.  Our view is inflation is peaking right now, and inflation numbers that are reported this summer will reflect this.  As a result of the visibility of inflation moderating,  the behavior of market participants and the Fed likely shifts.  We think this leads to the 10-Year Bond calming down in this 3% +/- 0.50 basis points zone.  And calming down is important because our takeaway is the year-to-date decline of the S&P 500 is attributable to the rising 10-Year yield causing P/E multiple contraction.  We believe the economy has pockets that may slow down but, the economy overall still grows, and we do not have a recession.  We think the Fed tightening will not continue to the point of pushing the economy into a recession and investors expecting a recession will be caught completely wrongfooted, reacting with “catch-up buying”.  

Most importantly, we think investors not paying attention to corporate cash levels and dividend growth are missing a material dynamic.  We do not buy into the view that “earnings are the next shoe to drop.”  We associate a high probability to earnings coming through in the attractive mid to high single-digit growth rates.  And with earnings growth, dividend growth and the cessation of earnings multiple contraction, stocks rise and equity income rises.

In short, we find owning S&P 500 companies attractive at current valuations and we see several positive potential drivers for dividend income in the making, such as corporate cash levels and earnings growth.  (The DCM/INNOVA High Equity Income Innovation Fund owns all 500 companies in the S&P 500.)  


Before Investing, you should carefully consider the Fund’s investment objectives, risks, charges, and expenses. This and other information is in the prospectus, a copy of which may be obtained by calling 888-484-5766. Please read the prospectus careufully before you invest. The Fund is distributed by Ultimus Fund Distributors, LLC. (Member Finra). Ultimus Fund Distributors, LLC is not affiliated with the other firms listed. Heckman Global Advisors is a division of DCM Advisors.
S&P 500 is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the Univeted States. It is one of the most commonly followed equity indices. 
Forward P/E is a version of the ratio of price-to-earnings (P/E) that uses forecasted earnings for the P/E calculation. While the earnings used in this formula are just an estimate and not as reliable as current or historical earnings data, there are still benefits to estimated P/E analysis.
Trailing P/E is a relative valuation multiple that is based on the last 12 months of actual earnings. It is calculated by taking the current stock price and dividing it by the trailing earnings per share (EPS) for the past 12 months. Trailing P/E can be contrasted with the forward P/E, which instead uses projected future earnings to calculate the price-to-earnings ratio.

Dividend Yield is a financial ratio (dividend/price), expressed as a percentage, that shows how much a company pays out in dividends each year relative to its stock price.
Estimated Long Term Growth EPS is the long-term projected earnings growth rate for a stock is the average of the available third-party analysts’ estimates for three- to five-year EPS growth.
Gross 1 Year Dividend Growth Rate is the annualized percentage rate of growth that a particular stock's dividend undergoes over a period of time. Many mature companies seek to increase the dividends paid to their investors on a regular basis. Knowing the dividend growth rate is a key input for stock valuation models known as dividend discount models.
Dividend Coverage Ratio The dividend coverage ratio indicates the number of times a company could pay dividends to its common shareholders using its net income over a specified fiscal period.
P/CF is a stock valuation indicator or multiple that measures the value of a stock’s price relative to its operating cash flow per share. The ratio uses operating cash flow (OCF), which adds back non-cash expenses such as depreciation and amortization to net income. P/CF is especially useful for valuing stocks that have positive cash flow but are not profitable because of large non-cash charges.
Forward Dividend Yield is the percentage of a company's current stock price that it expects to pay out as dividends over a certain time period, generally 12 months. Forward dividend yields are generally used in circumstances where the yield is predictable based on past instances.
30-Day SEC Yield (Subsidized/Unsubsidized) Represents net investment income earned by a fund over a 30-day period, expressed as an annual percentage rate based on the fund's share price at the end of the 30-day period.

All Definitions from Investopedia, Morningstar


The Latest From DCM