VIRT - Why Dividend Stocks Could Likely Pummel Growth Stocks In 2024

2024-01-07 09:00:00 ET

Summary

• Dividend stocks underperformed growth stocks in recent years.
• This is mainly due to the surge in interest rates.
• But as rates are cut, dividend stocks should strongly recover in 2024.

Over the long run, dividend stocks have generated far higher returns than non-dividend-paying stocks:

But lately, it has been the opposite.

Dividend stocks have massively underperformed the broader market and this is likely because of the surge in interest rates.

When interest rates were very low, investors poured a lot of money into high-yielding dividend stocks such as REITs ( VNQ ), BDCs ( BIZD ), MLPs ( AMLP ), and Utilities ( XLU ) to earn income in a yield-less world.

But as soon as interest recovered to 4-5%, investors sold these stocks, irrespective of their fundamentals, and went right back into bonds, treasuries, and money market funds.

You can clearly see this in the chart below.

Dividend stocks such as Crown Caste ( CCI ) suffered a lot more than growth stocks like Apple ( AAPL ) from the surge in interest rates:

But this market phenomenon has nothing to do with fundamentals.

Dividend stocks sold off because they were owned by investors who care about income so they were much likelier to sell once fixed income offered an alternative.

Growth stocks, on the other hand, are owned by investors who do not care about income so they simply don't care nearly as much.

But in a perfectly efficient market, it should have been the opposite.

The growth stocks that aren't paying a dividend should have dropped a lot more than dividend stocks in response to the surge in rates.

This is simply because the duration of their cash flow is a lot longer.

In most cases, growth stocks aren't generating much or any cash flow today but are projected to generate lots of cash flow sometime far into the future. Therefore, the present value of their cash flow should drop very substantially once you increase the discount rate in valuation models. The present value of $1 that's expected to be earned in 10 years is far lower than $1 that's earned today.

The longer the duration, the greater the impact.

Dividend stocks shouldn't be as heavily impacted because they are generating a lot of cash flow already today and their valuation multiples are typically a lot more reasonable.

But despite that, they dropped a lot more... with some dividend-paying sectors like Utilities still in a bear market even as the S&P500 ( SPY ) is hitting new all-time highs:

I believe that this means two things:

(1) Growth stocks are overvalued

Firstly, growth stocks are today way overvalued relative to the level of interest rates and this puts them at high risk of facing poor returns for years to come.

Stocks have faced many lost decades in the past, we are today way long overdue for one to occur, and valuations are stretched:

(2) Dividend stocks have a lot more to offer

Even following the recent rally, a lot of dividend stocks are still down substantially and trade at very reasonable valuations.

Just to give you a few examples:

• NextEra Energy ( NEP ) is down 62% and it is currently priced at 7.5x and offers an 11% dividend yield.
• Newmont ( NEM ) is down 47% and it is currently priced at 15x and offers a 4% dividend yield.
• Virtu Financial ( VIRT ) is down 46% and it is currently priced at 7x and offers a 5% dividend yield.

Even assuming that interest rates remain high, you could expect strong returns here because valuations are discounted, dividend yields are high, and growth is consistent.

If you earn a 6% dividend yield and the company manages to grow by 4% per year, that gets you to 10% annual total returns, ignoring any additional upside from repricing.

But it gets better.

The only reason why these dividend stocks are today discounted is because the surge in interest rates caused capital to flow away from them into fixed income.

But this also means that as soon as interest rates return to lower levels, we should see all that capital come right back into dividend stocks.

And the Fed just recently indicated that we should have at least 3 rate cuts in 2024 and many of the big banks like JPMorgan ( JPM ) and UBS ( UBS ) are expecting even larger rate cuts.

This has already caused the long end of the yield curve to drop by 100 basis points, and this led to a small rally across dividend stocks.

Even then, there's still lots of capital hiding at the short end of the curve in money market funds that are yielding 5%.

But for how much longer?

By mid-2024, rates could already be a lot lower and this will change the whole narrative.

Suddenly, investors will realize that the 5% yield that they were expecting was just a "mirage", and rush back to dividend stocks before they recover.

In that scenario, a lot of dividend stocks could potentially soar by 30-50% just as they recover to their previous peaks.

For this reason, we believe that dividend stocks are likely to pummel growth stocks in 2024. They dropped a lot more than they should have and the expected rate cuts should be a strong catalyst for them in the near future.

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