Why The Meme Stock Craze Is Bad News For Dividend Stocks

Summary

• Meme stocks like AMC and GameStop are surging again, driven by retail investors and the return of “Roaring Kitty” on Reddit.
• However, this is likely bad news for dividend stocks.
• We discuss why and how investors can mitigate some of this bad news.

Meme stocks are once again surging, with AMC Entertainment (AMC and GameStop (GME posting huge gains in recent days. This surge is largely due to the return of a Reddit (RDDT participant known as “Roaring Kitty,” who has sparked an army of retail investors to pile into shares of AMC and GME, driving up their stock prices and crushing shorts on those stocks.

While there are likely several causes for and implications of this sudden comeback of the meme stock craze, it is likely bad news for dividend stocks (SCHD . In this article, I will discuss why.

What The Meme Stock Craze Means For Interest Rates

The biggest reason why this meme stock craze is bad news for high-yield dividend stocks is because it indicates that financial conditions are still too loose. Therefore, the Federal Reserve may have to keep interest rates higher for longer. The reason this suggests financial conditions are too loose is that if retail investors have excess money to throw at highly speculative investments such as AMC and GME—both of which are companies with relatively weak fundamentals and poor long-term outlooks—interest rates are likely not high enough to motivate retail investors to pull money out of the economy and push it into savings accounts.

That said, seasoned investors such as Warren Buffett of Berkshire Hathaway (BRK.A (BRK.B , are taking a different approach, with his cash pile likely to reach $200 billion in the coming weeks as the attractive interest rates on cash, combined with a lack of attractive opportunities in large and mega-cap companies, likely motivate him to keep his cash out of the market. That being said, interest rates are apparently not high enough to have the same effect on the broader universe of some less rational retail investors.

What Higher Interest Rates Mean For High-Yield Dividend Stocks

The reason why higher interest rates for longer are bad news for high-yield dividend stocks in particular is that many high-yield dividend stocks have capital-intensive businesses. Given that they generate relatively low returns on assets, these companies tend to pay out high dividend yields and then raise capital through both debt and equity to reinvest in their businesses. With the cost of capital likely to be elevated for longer due to higher interest rates from the Fed, it becomes much harder for them to invest in growth projects or sustain their current business debt obligations. This could lead to lower dividend growth or even, in some cases, dividend cuts to offset the higher cost of capital.

For example, companies like Medical Properties Trust (MPW , which are facing a wall of upcoming debt maturities while dealing with troubled tenants, might have to eliminate their dividend altogether to try to keep their balance sheet afloat. Meanwhile, companies like NextEra Energy Partners (NEP , the renewable power finance arm of NextEra Energy (NEE , may have to cut their distribution if their cost of capital does not materially improve in the next few years, given their large amount of equity and debt obligations coming due in the near future. At the very least, they will likely have to cut back on their growth significantly due to the elevated cost of capital.

Another reason why higher interest rates for longer are bad news for high-yield dividend stocks is that they are often considered bond proxies. Therefore, their dividend yields are compared directly with risk-free interest rates when determining valuations. As a result, when interest rates remain higher, so does the market’s expected dividend yield for these stocks, which in turn pushes down their stock prices. This means that even if they have healthy fundamentals, they generally will deliver subpar total return performance in such an environment.

Some examples of this are Realty Income (O , Enbridge (ENB , and Brookfield Renewable Partners (BEP . Each of these businesses has delivered very solid underlying fundamental performance and have even continued to grow their dividend payouts at a healthy clip. However, due to rapidly rising interest rates, they have delivered subpar total returns in recent years.

Investor Takeaway

Given the ongoing GameStop craze, combined with sticky inflation data year to date, it is looking more and more likely that interest rates will remain higher for longer. As a result, investors in high-yield stocks may find it prudent to steer clear of the more risky, speculative names in the space like NextEra Energy Partners and Medical Properties Trust. Instead, they should consider focusing on high-yield stocks that are likely to continue delivering solid fundamental performance regardless of where interest rates head, such as Enterprise Products Partners (EPD , Mid-America Apartments (MAA , and Blackstone Secured Lending (BXSL . While it is hard to know how each of these stocks will perform over the short-term, they are likely to continue paying and even growing their attractive dividends moving forward, making them decent picks for income-focused investors with a long-term time horizon.