Investment Insights

Jeff Benjamin

High-end dividend plays may be too attractive for investors' own good

Some see the new darlings of income-seeking investors as played out

Jun 24, 2012 @ 12:01 am

By Jeff Benjamin

Although it is understandable that investors are placing a premium on dividend income during a period of historically low interest rates, current valuations indicate that it may be time for the dividend-oriented to exercise caution.

“Investors have been gravitating toward dividend-paying stocks for yield and as a safety feature, but the stocks have started to become expensive, and people buying them might be [ignoring] a new level of risk,” said Sudhir Nanda, director of quantitative equity research at T. Rowe Price Group Inc.

“Investors might be paying too much for some stocks at this point,” he said. “And to simply buy a stock for the high yield is not a good idea.”

Mr. Nanda's point about the valuations of higher-yielding stocks can be illustrated by comparing the forward price-earnings ratios of the top 20% of dividend-paying stocks by yield in the Russell 1000 Index with those of the bottom 20% of dividend payers.

Thirty years ago, the average forward P/E of the lowest dividend payers was 1.8 times that of the highest dividend payers.

And though the gap has fluctuated over the past three decades — spiking to 2.7 times in 2000 when dividend stocks weren't keeping pace with the technology bubble's valuations — the spread has been below 1 for the past 10 months.

Beginning last August, the average P/E of the low- dividend payers has fallen below that of high-dividend payers.

The current P/E of low payers — 14 — represents just 96% of the average — 14.66 — for the high-dividend payers.

The valuations for those that don't pay dividends have even been falling relative to high-dividend payers, with the average P/E of nonpayers falling below that of the high payers in both September and December of last year.

The average P/E for the nonpayers in the Russell 1000 is 15.09, or 1.03 times that of the higher-payers category.

POST-CRISIS PATTERN

The pattern has been unfolding since the start of the financial crisis in late 2008 due to a combination of low interest rates and a flight to higher-quality equity categories, according to Paul Rubillo, chief executive and director of research at Dividend.com.

“These aren't growth stocks, but they're being bought as if they are growth stocks,” he said. “When yields are being chased, valuations get thrown out the window.”

That new reality of dividends' actually driving up stock prices is not likely to fade away anytime soon, Mr. Rubillo said.

“This could continue for longer than any of us realize,” he said. “Almost every sector has been raising dividends, and people are starving for yield, so they're willing to pay higher valuations.”

Appreciating that investors will continue to seek income through dividends for as long as interest rates remain low, analysts and money managers advise against chasing the highest yields.

“These days, a yield of 3% to 5% is the sweet spot,” Mr. Rubillo said. “And we tend to shy away from anything with double-digit yields, because that's usually a red flag.”

Unlike bonds, dividend yields are not fixed. Thus, a rapidly rising or unusually high dividend yield typically represents a falling stock price.

Like a lot of professional dividend investors, Mr. Nanda prefers to look beyond the current yield to a company's dividend payout history and its likelihood to increase dividends.

“If you look at every stock market in the world, over long time periods, the companies with higher dividend growth rates tend to outperform all categories,” he said.

Considering that the median five-year growth rate for dividend payouts by Russell 1000 companies is nearly 12%, Mr. Nanda said he considers an annualized growth rate for dividend increases of between 10% and 20% attractive.

Even though more companies are introducing and increasing dividends in response to investor demand, Mr. Nanda said there is still plenty of room for growth.

“Right now, companies are only paying out about 30% of profits in the form of dividends, and that's well below the 35-year average payout of 46% of earnings,” he said.

STEADY GROWTH IS KEY

Morningstar Inc. fund analyst Daniel Culloton said investors should look for a steady dividend increase and avoid chasing higher yields.

“What I like about dividend growth strategies is that it's a simple way to get into a high-quality universe of stocks,” he said. “Companies that have the ability to grow dividends are going to be the higher-quality companies.”

Questions, observations, stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews.com

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