As the popularity of dividend-paying stocks continues to rise some investors wonder if there is enough room for everyone of if they could be in for an unpleasant surprise, perhaps even, "the b-word," Josh Peters, editor of Morningstar's DividendInvestor, sighs. "Bubble."
Inflows into dividend-paying stocks have picked up in light of recent volatility. Investors and baby boomers in particular view the relatively stable cash payouts as a dependable source of retirement income, according to Peters, who is also Morningstar's Director of Equity-Income Strategy.
But as money flows into big names such as AT&T, yields in telecommunications and other sectors have been declining. AT&T, for example, has fallen from a 6.06% yield in September of 2011 to 4.75%, according to analysts at Thomson Reuters. And investors have 1,908 dividend-paying stocks from which to choose, says John Kozey, a senior analyst at Thomson Reuters.
Verizon, as Peters points out, experienced a similar, though less pronounced decline. "When the stock price goes up faster than the dividend, the dividend yield goes down. And unless the natural growth rate of the underlying business and the dividend it pays is going up, then your total return is also suffering on a prospective basis," Peters says. And, adding to the issue, demand for dividends is likely to grow dramatically.
According to Peters, baby boomers are entering retirement largely without the fixed payouts of a defined pension from large companies such as General Motors and will have to create their own income to supplement their 401(k).
"That's going to force more and more and more people to go out and demand dividends at the core of their long-term portfolios," Peters says. "That doesn't mean fixed income no longer has any role to play, but it has become tough to look at fixed income as an on-going source of income that can keep steady with inflation."
It also means that certain sectors could become overcrowded as demand for certain companies pushes valuations higher, Peters says. He points to regulated utilities, real estate investment trusts, tobacco and telecom as dividend sectors that look "richly valued."
"People want low beta; they want low volatility," Peters explains. "They like a regulated utility that's pretty much going to be around paying its [dividend] through thick and thin. People are also very interested in trying to find yield wherever they can get it, so an environment with low interest rates and fixed income has a more profound effect on higher yielding stocks, makes them more valuable," Peters says. "That makes it a little more difficult to put together a good dividend portfolio right now, but it doesn't make it impossible."
Some wealth managers are re-evaluating their strategies in response. According to Mark Luschini, chief investment strategist at Janney Montgomery Scott, his firm suggested at the beginning of 2012 that investors start to make a rotation out of conventional dividend-paying sectors such as telecommunications, utilities and consumer staples and into energy, healthcare and technology.
"The fact of the matter is that the dynamic has changed," Luschini says. "And so, [that means] two things: One, we thought that some of those other sectors, [energy, healthcare and technology], had exceedingly attractive valuations that would be rewarded. At the same time, we also felt that the former, telecommunications, utilities, and consumer staples had valuations that had become fairly well stretched and might be vulnerable to under performance as investors continue to consider where they allocate money."
When choosing an appropriate dividend strategy, it's important to keep at least two major factors in mind, Peters says. They are the investor's individual time horizon and the sustainability of the dividend. Investors, Peters says, should make sure that they can make the commitment to hold the stock long enough to extract the cash return and weather the ups and downs in the stock price. A stock with a yield of four percent must be owned for a whole year to even access that return and another five years to make back 20% of the original investment assuming the dividend remains constant.
"In order for a dividend to really become meaningful you have to own the stock that pays it for a long time," Peters says. "And long-term buy-and-hold is out of fashion. People are skittish, they're scared, and they have been abused in the past by the way the market has behaved."
As for sustainability, investors will want to check a company's history to see how long it has offered its dividend and ensure that its earnings are not so volatile that a company is at risk of cutting that payout. Peters points to J.C. Penney and Supervalu as examples of companies whose growth could not sustain their dividends.
"The biggest risk associated with buying a stock for its dividends- even bigger than the valuation risk- is the possibility that business goes south and the dividend gets cut," Peters says.
Overall, Peters believes that even though there is a distinct possibility of dividend yields declining, it's still not time to "run screaming from the burning building" and pull out from dividend stocks.
Although supremely overvalued stocks do exist, a solid dividend position will generally be able to defend itself from becoming so expensive that buyers suffer major losses. If a regulated utility, he explains, traded for twice its value, then the yield would drop to half of what it should be, and theoretically investors will stop buying it for its yield before then.
"They tend to be almost self-puncturing bubbles," Peters says. "They tend not to get too out of hand. That's something that's one of the missed aspects of dividend paying stocks that's pretty valuable," he notes.
"If you've got a good well-established dividend, it tends to act like an anchor," Peters says. "It will encourage the stock to stay in the neighborhood of a reasonable price, give or take."