Investing is a strange activity. Just when you think you have the whole game figured out, the game changes. For example, many investors think a company's growth will bring with it the returns they need. Sometimes this happens, but truthfully, the market tends to work in long-term cycles when price-to-earnings ratios (P/Es) expand and in other cycles when P/Es contract.
This phenomenon has been documented in Ed Easterling's Unexpected Returns and in John Mauldin's Bull's EyeInvesting. The troubling part for investors is, when P/Es contract, the wind is in our faces instead of at our backs. That is, growth alone won't get the job done if investors as a group already expect that growth, and this is most often the case.
P/Es are still high...
According to Standard & Poor's, the current P/E for the S&P 500 is approximately 18.7 -- down from its peak of 42 in 1999 and 2000 but above the long-term average of 15 to 16 and well above the last four long-term bear market lows of 5 (1920), 8 (1932), 9 (1942), and 7 (1982).
Assuming P/Es continue to contract to average or even below average as they have in past bear markets, share prices will likely face an uphill battle. Of course, the effect will differ for each company, depending greatly on disconnected a company's share price and P/E are from its underlying profitability. Companies that trade at below-market P/Es and pay dividends, such as American Eagle Outfitters (NASDAQ:AEOS), face less of an uphill climb than those with P/Es well above the market's average that need to grow into their valuations, like Apple (NASDAQ:AAPL).
Yields are historically low...
As of December 30, 2005, the yield on the S&P 500 is 1.9%-- paltry compared to the 4.2% long-term dividend yield that the market has averaged. In fact, as recently as 1995 the yield on the S&P 500 was 3.5%, and in 1988, 1989, and 1991 the average yield was more than 4%. So it wasn't so long ago that yields were near the historical average.
It may seem strange for the current yield to be so far below average. But considering the higher-than-average P/E ratios over the last few years, it shouldn't really be a surprise. And P/E ratios are still working their way down. As share prices rise so do P/E ratios, but dividend yields fall. Mathematically, there is no other way, as Easterling correctly points out in his book.
This is because dividend payers like Packaging Corp of America (NYSE:PKG), International Paper (NYSE:IP), and Anheuser-Busch (NYSE:BUD), which yield above-market averages of 4.2%, 3.0%, and 2.6%, respectively, don't manage their dividends by maintaining a specific yield. Instead they pay out what remains of their cash flow after funding operational needs, maintaining their debt, and socking a little away for a rainy day. Case in point: Over the last 10 years, Anheuser-Busch has kept its payout ratio at 30% to 40% of its net income.
Foolish final thoughts
The historical data make a fairly convincing case that the current market is not too friendly to investors counting on growth and P/E expansion. But there are two things investors can focus on to position themselves well. The first is valuation. Companies do not fall entirely in unison. Pay attention to companies that offer the most attractive valuations, and P/E contraction can, to some extent, be mitigated. The second is dividends because dividend-paying companies provide a portion of the return up front. Of course, the best situation is to focus on undervalued stocks that also pay healthy dividends -- especially if you take advantage of the added gain from reinvesting dividends.
In our Motley Fool Income Investor service, Fool dividend guru Mathew Emmert scours the market to find companies that offer a compelling value and a yield greater than 3%. Over the past two and a half years, successful selections like Diageo (NYSE:DEO) and Snap-on (NYSE:SNA) have delivered returns that bested the market by an average of four percentage pouints. So if you'd like to know where to get an above-average yield for a below-average price, click here to take a free trial to Income Investor. You'll enjoy access to the new issue as well as all the issues in the archive. Or subscribe and take home a free copy of The Motley Fool's Stocks 2006 report, which features 12 great investing ideas for the year ahead.
Nathan Parmelee owns shares in American Eagle Outfitters but has no financial stake in any of the other companies mentioned -- though he does enjoy Diageo's products. You can view his profile here . The Motley Fool has a disclosure policy. Anheuser-Busch is a Motley Fool Inside Value selection.
