Of all the stocks we’ve owned over the years, none is nearer and dearer to my heart than Realty Income O. “The Monthly Dividend Company” is much more than a slogan; it’s the spirit that animates every decision Realty Income makes with shareholders’ money. Our very profitable history with the stock dates back to July 2006, when I bought 300 shares for our original Dividend Portfolio (the predecessor of today’s Builder and Harvest accounts) at $22.23 apiece. When
most other real estate investment trusts (REITs) were slashing dividends during the crash, Realty Income kept raising its dividend (albeit slowly). Through it all, we’ve more than doubled our money, earning
an annualized, time-weighted return of 17.6%.
However, as far as this performance is concerned, there’s been more going on than just our monthly dividends. My first purchase of the stock carried an original yield of 6.3%. Since then, dividend growth has averaged 3.7% a year. By our usual math—dividend yield plus dividend growth—we should have earned an annualized return of about 10%,
give or take. So where did the rest come from? As they say, a picture is worth a thousand words. The chart below compares Realty Income’s dividend yield to the yield on 10-year Treasury bonds. As the price of a fixed-rate bond goes up, its yield goes down, and vice versa. This formula is a little more complex for a stock seeing as how the dividend can change, but even a cursory inspection suggests a rather strong relationship. Except in 2008–09,when the crash sent interest rates plunging and even the highest-quality stocks got hammered, there’s
a strong relationship between falling interest rates and a falling yield (read: rising price) for Realty Income’s common stock. Given what has happened to interest rates, I think it’s fair to treat much of our hefty return as a windfall.
[A chart showing the high correlation between the yield of O and 10 year Tbonds is also included which I can't cut and paste .]
Our situation with Realty Income is hardly unique. Slow-growing Verizon VZ now yields just 4.4%, down from around 6.0% three years ago, and the stock now garners a big P/E premium to the market average. (As you might expect, AT&T T is in similar shape.) Regulated utilities in the U.S. look overvalued across the board, with only Harvest holding American Electric Power AEP trading below its fair value
estimate out of the 30 that we cover. Meanwhile, most REITs simply baffle me. Here we have a group of stocks once known primarily for their rich dividends, only to see three quarters of REITs slash theirs in the last recession. Scarcely three years on, valuations are at record highs and dividend yields are at record lows.
How about the tobacco stocks? Threats from litigation and regulation have subsided in the last decade and despite steadily declining volumes, the industry’s stocks have had a habit (pardon the cruel pun) of being undervalued and therefore over-profitable. In late 2009, when Altria MO traded at 10 times earnings and offered a 7.5% dividend yield, I overcame my long-standing skepticism and bought the stock. We’ve done very well since, but Altria now trades at a 4.6% yield and a forward P/E of 16. There’s no definitive way to trace the historic valuation of the purely domestic tobacco business that Altria has become, but for all I know, this is the richest rate the Marlboro Man has commanded
since the Nifty Fifty era.
Against all odds, we’re camped out at what has become Wall Street’s most popular intersection: low business risk and high dividend yield. With interest rates at all-time lows, an economy stuck in neutral at best, and the swelling ranks of retirees grasping for reliable income, it’s no accident that our style is now in style. Rising prices, though, can create problems—
not just for new buyers, but even for existing shareholders. What do you do with windfalls like this?
