Why Dividend Investors should Favor Gold Stocks over Housing Stocks in the Fourth Quarter
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Dividend paying stocks have been emphasized in significant scale as the low interest rate environment rolls from one year to the next. The thesis and historical evidence does support holding dividend paying stocks over non-payers. However, I try to highlight to investors that there is more than just the dividend yield to look at when evaluating potential buys, e.g. the growth rate in dividends is more meaningful than the actual yield.
I highlighted a couple months ago the potential for underperformance among dividend paying stocks with high exposure to Europe. The obvious highlight of the bunch was McDonald’s (NYSE: MCD) and it created a bit of controversy at the time. The stock has underperformed the S&P 500 by 5% since I highlighted it as the weakness in Europe showed through on third quarter results. In fact, the stock is the second worst performing member in the Dow Jones Industrial Average this year. I think the thesis remains in its infancy as Europe is vastly weaker than other developed economies, namely the United States. As the calendar approaches year-end, there could be an opportunity for investors to again dig a little deeper among the over-hyped dividend stocks to find reasons to wait for better entry points or take gains ahead of the looming tax changes. Below are two such stocks that may be ripe for underperformance in the fourth quarter.
Too Much of a Good Thing
Housing has clearly bottomed, although whether a sustainable rally is underway is much more debatable. One thing is for sure, housing related stocks have had one heck of a run in 2012. Home Depot (NYSE: HD) is a widely owned stock that has had such a run with a year-to-date total return of 50%! Much of the upside has to do with a housing rebound as well as a sustainable dividend. In fact, the significant run-up in the shares has pushed a near 3% yield at the start of the year to just 1.8% today.
Two factors may hold back Home Depot in the fourth quarter. First, valuation based on both sales and earnings is at a ten-year high. This doesn’t always signal the end of outperformance, but it likely reduces the margin of error that prudent investing is based on. The chart blow shows that the trailing twelve months price-to-earnings is at 22x, a 55% premium to the S&P 500. The EV/Sales ratio has also made a significant move.
The second factor is the looming tax changes that are set to take effect as the calendar rolls into 2013. The two relevant ones are the capital gains tax rate moving from 15% to 20% and the dividend tax rate falling in line with ordinary income. The dividend rate in some cases could move from 15% to 39%! Investors will start to focus on this issue in the fourth quarter and seek to minimize the impact on their portfolio. One obvious and effective way is to realize the gains in 2012, when the tax rate is lower. Under this likely scenario, the best performing stocks of the year are the likely sell candidates as we approach the end of the year. This could put enough marginal selling pressure on Home Depot, that when combined with its elevated valuation, leads to underperformance in the fourth quarter of 2012.
Whirlpool Corp (NYSE: WHR) is another housing benefactor as it's the largest appliance maker in the world. The company just released quarterly results that are being viewed favorably by initial market reactions. The company did increase forward guidance, but sales and earnings growth remain a challenge. Fortunately for the shares, valuation is much more reasonable and beating pessimistic expectations has propelled the shares to an 85% advance on the year!
Like Home Depot, Whirlpool’s strong advance may leave it a likely sell candidate among those looking to realize tax opportunities in the fourth quarter. Unlike Home Depot, which has returned strong operational results, Whirlpool faces notable headwinds in generating consistent sales growth. North America contributes 50% to the bottom line and 3Q sales were only able to advance 2% versus a year earlier. Europe, at 17% of total sales, was a disaster with sales plunging 10% annually on a constant currency basis. Investors will need to scrutinize and listen to the 3Q conference call given that the CEO of Electrolux, the world’s second largest appliance maker behind Whirlpool, downgraded their assessment of the U.S. appliance market.
The opposite also holds- that underperforming stocks are less likely to see selling pressure at the margin. This doesn’t mean investors should jump into losing stocks that face notable secular challenges. Instead, investors should focus on areas that offer compelling opportunities that have thus far been ignored by the market. The obvious industry to me is gold stocks.
I highlighted Kinross Gold (NYSE: KGC) back in July and it has advanced 30% in just three months. The thesis still holds, but despite the near-term success the shares are still down almost 9% on the year. Kinross is a very aggressive play, but more conservative investors can still look to the industry leader, Barrick Gold (NYSE: ABX). Barrick Gold generates nearly $40 billion in annual revenues, pays a consistent dividend, has significant mine diversity, and operates in politically stable countries. Adding to the allure is the fact that gold historically performs very well in November and December and often times reaches its yearly high in the final month of the year. According to Ned Davis Research, November has produced the highest average monthly gain in the price of gold (+2.2%) since the links to the gold standard where removed in 1973. Throw in some QEternity and another upcoming FOMC Meeting to further clarify the committee's move away from calendar based guidance and toward data-centric guidance and gold has plenty of upside into year's end.
Foolish Bottom Line
Stick with dividends, they do work. But dividend paying stocks is a big universe and in it lies great opportunities as well as some hidden pitfalls. Dividend stocks with huge gains through the first three quarters may be vulnerable for the next couple of months. This includes the home building group and names such as Home Depot and Whirlpool. Gold stocks have several tailwinds that point to outperformance in the fourth quarter despite only so-so results since QE3 was officially unveiled. Be patient with gold. It remains in a secular bull and QE will be with us for longer than many think.
market8 owns shares of Kinross Gold. The Motley Fool owns shares of McDonald's. Motley Fool newsletter services recommend The Home Depot and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.