In the past several months, we have seen a trend in the investment strategies that ETF and mutual fund families are promoting: dividend paying/low volatility strategies.  They are doing this because that is what is selling.  Just recently, we met with such a fund that has seen their assets grow from $900 million at the beginning of the year to $2.5 billion today.  The flood of money into dividend paying strategies is tremendous and, we believe, will prove unprofitable over the next several years because these stocks are overvalued.

In 2009-2010, we met with many fund families.  The overriding strategy many of them were promoting was international – especially emerging market equity funds.  The story was compelling:  there was a new world order and the BRICs (Brazil, Russia, India and China) were leading the way.  The United States had a new President who was not business friendly.  Clients should invest money overseas to protect against the potential risk of inflation caused by our debt levels.  When we asked “What are you seeing from other advisors?”, the response was that “most advisors we know have 30%-50% of their clients’ money in international with a majority of it being in emerging markets”.  At the time, and according to our THOR model, international (and especially emerging market) equities were selling at an unattractive valuation.    Fortunately, this led us to steer away from the BRICs strategy.  We had a very low exposure to international equities with no exposure to emerging market equities.  Being underweight international equities proved to be the correct position over the next few years.

Today, we believe the situation is very similar relative to the dividend paying funds.  We have our lowest US large company equity exposure in our history, which is similar to what we had in international equities in 2009-2010.  Our proprietary model is telling us that US large company stocks are overvalued.  One easily illustrated point in looking at the “safe” consumer staple companies many investors are purchasing for the dividend they pay in the current low interest rate environment is the dividend payout ratio.  As you will see, these stocks are not as “safe” as they used to be.  Below is a chart of some of the most widely recognized US consumer staple companies showing how much of their earnings they paid out in dividends in December of 2005 compared to today.

Company Dividend Payout Ratio of Earnings

Source: ycharts.com

Why is this important?  When a company pays out a high percentage of their earnings as a dividend, there is little cash left to grow the business or handle a crisis.  For example, if interest rates start to rise, these companies will have to pay higher interest costs which will reduce earnings and raise the payout ratio even higher – maybe to more than what the company is earning.  At that point, will they borrow more money to pay the dividend, sell more shares or cut the dividend?  In addition, when buying a company, an investor has the expectation that earnings will grow and the company will be more profitable in the future.  With such a large percentage of current income being paid to shareholders, these companies will have a hard time expanding their businesses.

It seems to us that investors are investing like 1^st graders play soccer – the bumblebee approach.  This is where the kids surround the ball and kick it.  It looks like a blob (a bumblebee) going up and down the field.  The child outside the bumblebee usually ends up scoring when the ball is kicked out of the bumblebee and they find themselves in an open field and score a goal.  In our opinion, those investors joining the bumblebee of buying US dividend paying consumer stocks today will find investing in these stocks unprofitable over the near future.