The stock market has seen double-digit returns in each of the last two years, following the collapse of both the credit and equity markets in 2008. To underscore the unusual strength of this recent stock market recovery, an investor would have to go back to 1986 to see a two-year period of comparable performance.
With equity prices entering a range of fair value based on a number of metrics, primarily earnings multiples and the risk premium, investors may reasonably wonder if there are any areas that still offer an opportunity for solid returns.
A stock’s return is made up of capital appreciation plus income. In an environment like our current one, where equities appear to be reasonably valued, the income portion of a stock’s return takes on more significance.
Dividend paying, particularly larger sized, companies continue to offer attractive return potential in a fairly valued market. With low interest rates on bonds, investors are earning more income from dividend paying stocks than the yields they are receiving on fixed income investments.
Large caps are the blue chips of the stock universe that represent some of the largest and most established companies, and as a result generally have lower business risk to their operations and cash flows. Dividends add a positive component of return and are generally more stable through time.
Even through the recent crisis and recovery, high-quality large caps have underperformed. On a forward earnings multiple basis, large caps are hovering between 13 and 15 times earnings, which is below the average of 17.5. In short, large caps still offer upside, especially as the market begins to favor higher quality companies as we have started to see over the last six months.
Focusing on large caps that offer higher dividends is a way for investors to enjoy an income stream with the potential for price appreciation down the road. At a time when concerns abound about the hot money moving in and out of emerging markets, the conservative equity investor may be more satisfied with the more cautious approach of higher dividend paying large cap stocks trading at attractive relative values.
