Dangerous quest for yield

Over the last year or so, a lot of well respected [value oriented] fund managers have successfully identified the danger of holding US Treasury bonds. The yields are at or close to their all time lows. The supposed "risk free returns" come with a "return-free risk"-- an eloquent quip from James Grant, I believe.

I must say that I don't disagree with that.

When asked how to mitigate this risk, some but not all, fund managers have suggested the answer may be US stocks that have a long history of increasing dividends and currently yield much higher than the 10 year treasury. This sounds like an excellent alternative to the bonds of a heavily indebted nation.

But caution is warranted here.

According to the Q2 2012 commentary from Oakmark funds:

...over the past 60 years, the 100 highest yielding stocks in the S&P 500 have on average sold at about three-quarters of the S&P 500 P/E multiple. The high yielders[sic] are typically more mature, slower growth businesses that deserve to sell at a discount P/E... Historically, high-yield stocks have been cheap stocks.

Today’s high-yield stocks are quite a different story. The 100 highest yielders in the S&P 500 have a much higher yield than the index – 4.1% vs. 2.5%. The S&P 500 today sells at 12.9 times expected 2012 earnings. If the high yielders sold at their 60-year average discount, they would be priced at less than 10 times earnings. Instead, today’s top 100 yielding stocks sell at 13.9 times expected earnings, more than a 40% relative premium to their historic average. The only reason they yield more than the rest of the S&P is that they pay out so much more of their income – 57% vs. 32%.

It appears that the well meaning advice those fund managers has worked. The valuation of these high dividend payers is well above the historic norms, thus exposing them to major price correction.

An intelligent investor must not sacrifice valuation in favor of yield, no matter how reliable the dividend appears.

Full Disclosure: N/A