Debating the Use of Dividend Yields as Yardsticks

Few indicators are so widely watched when evaluating the stock market as dividend yields. And few indicators seem to be working so poorly these days.

How else can you explain this year’s rally, which has seen the Dow Jones industrial average climb nearly 16% to record-high territory?

According to dividend-yield enthusiasts, the rally never should have happened. They view the market as expensive whenever yields in the aggregate drop below 3% or so. By this measure, stocks were overpriced at the start of the year and have become even more so today.

Has the indicator lost its predictive value? Or is it only a matter of time before prices come crashing back to earth?

Such questions are on the front burner of debate among investors these days.

Dividend-seeking mutual-fund managers disagree about the implications. While all managers certainly are aware that lower yields make it harder to find bargains, many say they aren’t disturbed by the market’s valuation level.

David Tripple, chief investment officer for the Pioneer fund group in Boston, says his firm doesn’t try to time the market and thus doesn’t follow the overall yield as a direction indicator.

Pioneer’s Equity-Income Fund has managed to remain nearly fully invested in the current climate. Improving corporate profits have led to dividend increases at many firms in recent months, says Tripple. Pioneer Equity-Income has relied largely on utility and financial stocks to keep its yield above 3%.

Similarly, William Lippman, who runs the San Mateo, Calif.-based Franklin Rising Dividends Fund, says he’s not apprehensive.

Lippman says he doesn’t care so much about a company’s dividend level per se but instead seeks out firms likely to boost their payouts over time. About 150 companies meet his requirements, which include a history of having boosted dividends in at least eight of the past 10 years.

“It’s harder to find bargains, but there are some out there,” Lippman says.

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But William Stromberg, manager of the T. Rowe Price Dividend Growth Fund in Baltimore, continues to have faith in the dividend-yield yardstick. Consequently, he has boosted his fund’s cash position to 20% from 10% at the start of the year because he views the market as expensive.

“I feel this is the best valuation indicator because dividends, unlike earnings, are cash payments to investors that can’t be manipulated through accounting policies,” he explains.

The yield on a specific stock reflects the company’s per-share dividend payment divided by its price--a $50 stock paying $1.50 a year in dividends would have a 3% yield, for example. The market’s overall yield is simply an average of the dividend payments made by dozens or hundreds of corporations, depending on which index you track.

Blue-chip stocks as measured by the Standard & Poor’s 500 index were paying only 2.9% on average at the start of 1995, and the current rally has sliced that figure to near 2.6%.

“That’s the lowest reading we’ve had this century and a warning sign that stocks have been picked over,” says Stromberg.

Over time, the market’s yield has tended to range between 6% during bearish nadirs and 3% at bullish peaks. A payout of about 4.5% is considered normal.

But those standards might be in need of revision. Market yields have stayed below 4% for most of the past decade. That would imply a high-risk environment, yet the period has been extraordinarily profitable for investors, during which time the Dow industrials roughly tripled in price.

Critics believe the dividend-yield yardstick no longer carries the weight it once did. Among the reasons are that investors would rather generate most of their returns from appreciation instead of dividends, because capital gains are taxed at lower marginal rates than income. Also, companies often prefer the flexibility of using cash in other ways to enhance shareholder returns--by paying down debt, reinvesting in their business or repurchasing shares, for example.

Fund managers who target dividend-paying stocks have mixed viewpoints of today’s market.

But even with its poor recent predictive record, the dividend-yield indicator isn’t likely to disappear from the scene. Valuation measures have a tendency to come back into vogue just when you think they have lost all of their usefulness.

Rather, the lesson of the last several years is that it can be hazardous to put too much faith in any one indicator. The stock market is simply too complex to be explained by a single barometer.

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It has been a case of musical chairs at Invesco Funds of Denver, where five of the company’s stock portfolios have received new managers.

The largest fund affected is Invesco Growth, where Doug Pratt joined Dalton Sim as co-manager. Pratt had been at the helm of Invesco Emerging Growth, now headed by Jeff Schroer.

The other three funds with new managers are Invesco’s Strategic Environmental, Strategic Energy and Worldwide Capital Goods portfolios.