For income investors and their advisers, bonds have been as attractive as a bag of week-old smelt. So it's not surprise that investors have been bidding up prices of dividend-paying stocks. The question is: Have they gone too far?
Quite possibly. But Tony DeSpirito, co-manager of BlackRock Equity Dividend Fund, says that stocks with a good record of rising dividends could be the big exception.
Conservative investors have long loved dividend stocks, such as utilities and telecommunications stocks, for their solid balance sheets and reliable payouts. Low interest rates in the U.S. and abroad, however, has taken that love to a new level. So far this year, for example, mutual funds that
invest in utilities stocks have gained 17.74%, according to Morningstar, and equity limited partnership funds have soared 21.22%.
As prices have risen,
yields have fallen. The Utilities Select Sector ETF (XLE) carried a 2.79% yield at the end of August, down from 3% a year earlier. Not surprisingly, valuations have risen as well.
“Utilities have historically traded at a median relative P/E ratio of 0.85x against the S&P 500, but has been bumping along near 1.00x since the Fed began depressing interest rates,” Scott Opsal, research director for the Leuthold Group, wrote in a recent commentary. “In other words, the desirability of yield and safety is so strong that investors are willing to make an even-up trade between utilities and the S&P 500, taking a 5% lower EPS growth rate in this sector to tap into perceived safe dividend providers.”
On the one hand, the popularity of high-quality, high-yielding stocks shouldn't be surprising. “The decade of the 1990s and the run-up to the tech-bubble didn't reward quality and yield, but since the tech-bubble top, this style has earned a consistent return premium,” Mr. Opsal noted.
Nevertheless, the passion for dividend yield is worrisome. “In our experience, whenever investors are “chasing” a theme, the ultimate outcome is usually unpleasant,” Mr. Opsal added.
Mr. DeSpirito agreed that some parts of the dividend landscape are richly valued. “Some of the traditional bond proxies have been bid up in price,” he said. “In this low-yield world, some people have become more focused on current income and have stretched for yield.”
But investors don't have to make the choice of avoiding dividends, Mr. DeSpirito said. Companies with a record of raising dividends are more attractive than usual, in part because they dole out their dividends cautiously. Companies that raise their dividends regularly have to be careful that there's more room to raise without stretching their balance sheets.
And companies that
raise their dividends regularly also tend to be confident about their ability to continue paying those dividends. Wall Street clobbers companies that cut their payouts. Because of that, companies that raise dividends regularly make sure that their dividend increases are in line with future growth.
Companies that raise dividends regularly often fare well when interest rates rise, Mr. DeSpirito said. “In our portfolio, we're overweight on banks, which are growing dividends faster than the market,” he said. Bank earnings typically benefit from rising interest rates.
“They provide a nice hedge against rising rates,” Mr. DeSpirito said.
Not all dividend growers are created equal, however: Mr. DeSpirito is underweight
consumer staple companies, in part because they no longer as much of a powerful distribution edge as they once did. Consumer choices were limited by the amount of shelf space at a grocery store or drug store.
The Internet has created unlimited amount of shelf space for new brands and products, he said: “It's easier to start new consumer product companies, and large companies have had to buy competitors.”
