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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management biweekly asset allocation report for September 16, 2024. I'm Phil Adler. Large cap stocks aren't what they used to be. Confluence Investment Management associate market strategist Thomas Wash joins us today to discuss why investors who are looking for dividends may need to refocus. Thomas, I've always associated healthy dividend yields with large cap older companies and assume that if you're searching for dividends, a large cap index fund was a logical place to be.
Phil Adler:What does the evidence say? Is this no longer true?
Thomas Wash:Hi, Phil. Thank you for having me. When discussing a company's life cycle, we typically think of stages like the launch, the growth stage, the shakeout period, its maturity, and its eventual decline. Because small cap companies are assumed to be earlier in their development, they've often been seen as places for investors to seek capital gains. Conversely, large cap companies are thought of as being older and more mature and are considered to have reached a size where they can begin returning some of their earnings to shareholders.
Thomas Wash:However, our research suggests that this is no longer true today, and it hasn't been true for the past 7 years as we will discuss later on in the podcast.
Phil Adler:Why is the traditional dividend landscape changing?
Thomas Wash:Much of the shift in estimated dividend yields between these indexes can be attributed to changes in their underlying composition. In recent years, technology companies have gained significant weight in the S and P 500. If you look at the Magnificent 7, they now account for nearly 30% of the entire index. Now conversely, dividend paying sectors like financials and real estate have grown in their representation within the small cap index. Many companies within these sectors have transitioned from large and mid cap classifications due to factors such as rising interest rates and the economic downturn caused by the pandemic over 4 years ago.
Phil Adler:And at the same time, those young technology companies have simply been outgrowing their initial small cap status and taking over an increasing percentage of larger cap index funds?
Thomas Wash:Well, so the dominance of tech giants in the S and P 500 has undoubtedly contributed to its lower dividend yield, especially when compared to its smaller cap counterparts. However, there's more to the story. The rise of these tech behemoths is partly result of the challenges faced by smaller companies. You know? In the past, launching a tech startup and going public was a relatively straightforward process.
Thomas Wash:But the Sorboni Oxley Act introduced significant hurdles for smaller firms, making compliance more difficult and costly. So as a consequence, many of these tech companies decided to stay private waiting for a more favorable time to go public. And this shortage of IPOs on small cap exchanges is a key factor explaining the scarcity of tech on the small cap indexes.
Phil Adler:And as we look at what now constitutes a larger proportion of the large cap index, these large cap technology companies, is it true that they generally do put less emphasis on dividends?
Thomas Wash:Well, like, historically, tech companies often prioritize growth over returning profits to shareholders. They typically invest earnings to capture more market share and hopefully have some type of monopoly power. As a result, investors in tech stocks focus more on the capital gains rather than the immediate income, driven by the belief that these companies will continue expanding leading to substantial stock value increases.
Phil Adler:And focusing back to the small cap sector, has the percentage of dividend paying small caps been growing?
Thomas Wash:The small cap space has seen a decline in high growth firms while companies focus on dividend payouts have in fact grown. That is correct. This shift reflects rising investor risk tolerance in recent years. You know, while dividend paying companies offer steady income, they're not typically linked or known for their strong growth. However, in a capital gains driven market, even then, like, these small growth oriented companies have not only gained visibility, but they've kind of outgrown the small cap index, which has also contributed to the relatively high concentration of dividend paying companies within the small cap space.
Phil Adler:You mentioned that as we look at sectors within the small cap world, real estate and financial services have been growing. Can you go into a bit more of some of the reasons behind this?
Thomas Wash:Sure. Financial services and real estate firms have increasingly dominated the small cap index largely due to the fallout from rising interest rates. You know, the commercial real estate market has been particularly hard hit, and higher rates have made it difficult for property owners to refinance. Now meanwhile, financial services companies, particularly these small regional banks, have grappled with the consequences of duration mismatch, which is basically a legacy of the pandemic. You know, a lot of these banks had a large holding of very low yielding treasury securities.
Thomas Wash:As a result, many of these firms found themselves ill prepared for the Fed rate hikes that took place in 2022. So, like, you know, struggling to attract savers with higher deposit rates, these companies' stock prices have taken a hit leading to the migration to small cap index.
Phil Adler:A little bit more as we dig a little deeper, what economic conditions have encouraged the emergence of financial services in real estate firms within the small cap group?
Thomas Wash:Like I alluded to, previously, you know, these sectors are highly vulnerable to interest rate changes. Lower rates can boost activity in the commercial real estate market, benefiting firms looking to adjust their holdings. This can also help prevent defaults for struggling property owners. Additionally, lower rates can alleviate this, you know, maturity mismatch issues that banks have faced, making it easier for them to attract deposits. A stronger economy with improved prospects for our corporate earnings can also enhance the appeal of these sectors, especially for investors seeking higher dividend payouts.
Phil Adler:Are the trends we're talking about, do they do they suggest that small cap companies that offer higher dividend payouts are maybe less focused on growth than small caps used to be?
Thomas Wash:Higher dividend payouts aren't always a sign of a large company. They often reflect specific characteristics of the index. Despite the size, many small cap companies offer significant growth potentials. For instance, crypto and AI related firms have been attracting considerable attention. Even established names like Etsy, which recently fell down into the S and P 600, could see an eventual resurgence.
Phil Adler:I've always assumed, Thomas, that a small cap index fund is where you find predominantly newer companies that are just starting out. What do these statistics tell us?
Thomas Wash:Well, you know, the statistics paint a surprising picture of today's equity market. It's like they've been hit with a reverse fountain of youth. Back in 1980s, companies listed on the S and P 500 had an average lifespan of about 36 years. Fast forward today, and the average has been cut in half. To put that in perspective, the average s and p 500 company is too young to drink and barely old enough to vote.
Thomas Wash:It's no wonder why these companies are hesitant to pay dividends. After all, when was the last time you saw a teenager willingly folk over their allowance? Like, come on. Ironically, small cap stocks despite being generally seen as riskier actually have a weighted average lifespan of 32 years. This suggests that while large cap companies may be aging prematurely, smaller firms are still holding their own on the dividend front.
Phil Adler:These seem like significant trends. Do do you think these trends we've been discussing will continue?
Thomas Wash:Well, personally, I do believe we'll eventually see a return to normal conditions. You know? Earlier this year, Meta and Alphabet, for the first time, paid a cash dividend. This trend is likely to continue as these firms continue to struggle to sustain rapid growth that investors expect. In the small cap space, I anticipate some financial services and real estate firms transitioning away from low cap market capitalization as a commercial real estate sector starts to stabilize.
Phil Adler:As we sum up, you suggest in your report that investors seeking dividend income may need to focus a bit more on small caps. As we sum up, you suggest in your report that investors seeking dividend income may need to focus a bit more on small caps. Do you think the market has recognized the dividend appeal of small caps, or is there an opportunity now for investors?
Thomas Wash:You know, the way I see it as small cap earnings improve, we believe that these stocks offer significant upside potential for investors. You know, a drop in interest rates could further boost the bottom line, particularly for firms with variable rate loans. With the dual benefit of dividend income and capital gains appreciation, small caps could be a valuable addition to any investment strategy, especially if the economy proves more resistant than current market expectation.
Phil Adler:Thank you, Thomas. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. Also, this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stowell.
Phil Adler:I'm Phil Adler.