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Is There a Bubble In Dividend Stocks?

In the interests of brevity, I can make the answer short.

No. There is not a bubble in dividend-paying stocks.

This is not to say that defensive sectors of the market are not modestly overpriced relative to more cyclical sectors or that, when faced with paltry rates on bonds, some investors have not taken to chasing yield where they can find it. Dividend-paying stocks have certainly outperformed their non-dividend-paying sisters in 2012, and some dividend-focused indexes—such as the S&P Dividend Aristocrats—sit near all-time highs even while the rest of the market sells off.

But suggesting that there is a “bubble” in dividend investing implies that shares are drastically overpriced or that investors have wild, unrealistic expectations of future profit. In looking at a sample of American blue chips that often come up dividend screens, it is hard to make such a case.

Let’s start with that most iconic of American companies Coca-Cola ($KO). Coke is a special case because it is both a high current-dividend stock and a serial dividend grower. In addition to being one of Warren Buffett’s largest holdings, Coke is a constituent of the popular Dow Jones Select Dividend Index ETF ($DVY) and the Vanguard Dividend Appreciation ETF ($VIG). Long suffering readers will remember that VIG, which requires its stock holdings to have at least 10 years of consecutive dividend increases, is my favorite ETF for long-term portfolio growth and a core holding of my ETF portfolios.

Coke trades for 17 times estimated 2013 earnings. To be sure, this is more expensive than the 13 times earnings of the broader S&P 500. But for a company of Coke’s quality and safety, it would hardly seem excessive. Coke may not be a screaming buy at current prices, but it would hardly seem overpriced.

The story is much the same among other popular dividend-paying blue chips. Johnson & Johnson ($JNJ), Wal-Mart ($WMT) and Procter & Gamble ($PG) trade at 12, 13, and 16 times 2013 estimated earnings, respectively. Again, this hardly suggests nosebleed valuations on the verge of crumbling.

Moreover, the investors piling into these stocks are not doing so in hopes of getting rich quick. This is not 1990s tech mania or 2000s condo flipping. Their goals are far more modest; they are looking for stable and consistent dividend growth that will outpace inflation over time.

When the market shifts back into “risk on” mode, every stock and ETF I’ve mentioned thus far in this article will likely underperform the broader S&P 500.

This is, of course, a problem for professional money managers who use the S&P as their benchmark. But individual investors—and particularly those in or near retirement—care much less about relative performance and far more about generating a stable income that does not depend on portfolio drawdowns.

It is ironic; while Wall Street has become more of a casino than ever in recent years, investors have become far more reluctant to risk their retirement to the whims of the market. Twelve years of very difficult market conditions have taught them that capital gains can be fleeting and that depending on them is a gamble they can’t afford to take.

This change in sentiment is not an incipient bubble, but I believe it is a long-term regime shift in investor preference that should be welcomed. I hope it lasts.

As investors demand higher yields, company boards will eventually acquiesce and give them what they want. They certainly have the capacity to do so. According to Howard Silverblatt, Standard & Poors’ research guru, the dividend payout of the companies of the S&P 500 is only 32% of earnings. This compares to a historical average of 52%.

This is an unambiguous good. The payment of a dividend has a way of focusing management attention and discouraging wasteful empire building. It aligns management with the preferences of long-term investors rather than short-term speculators. And in an age of scandals, dividends, unlike paper earnings, cannot be fabricated.

All of this reverses the trends of the past half century that spawned the cult of equity.  And again, it should be welcomed.

Disclosures: Sizemore Capital is long DVY, JNJ, PG, VIG, and WMT. This article first appeared on MarketWatch.

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Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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SDOG: A New Dog for an Old Trick

If you’ve been trading or investing long enough, you’ve no doubt come across the Dogs of the Dow strategy. In its most popular form, an investor buys the 10 Dow stocks with the highest dividend yield, holds them for a year, and then starts the process over again.

The Small Dogs of the Dow uses the same strategy but with only the top five highest-yielding Dow stocks. Years ago, the Motley Fool had a similar twist as well. They eliminated the highest yielding Dow stock in the belief that the cheapest stock might be cheap for a reason and then made an equally-weighted portfolio of the next four.

Though the name “Dogs of the Dow” has a nice ring to it, there is nothing particularly unique about this strategy. It is a mechanical value trading strategy designed to find stocks that are temporarily cheap as measured by their dividend yield. Nothing less and nothing more.

Innumerable studies have shown that simple value strategies outperform the market over time. To give two high-profile examples, Ibbotson and Associates and the academic duo of Eugene Fama and Kenneth French did similar studies that found that value stocks, as measured by low price-to-book ratios, outperform growth stocks over the long run. The Dogs of the Dow is just a simple way to implement these insights in a real-world portfolio.

It’s also a rather poor one.

Let’s start with portfolio size. There is absolutely nothing wrong with running a concentrated portfolio if you’ve done your homework and have a high degree of conviction in your investment picks. How do you think Warren Buffett produced those legendary returns of his over the decades? It wasn’t from being a closet indexer.

But in running a mechanical model like the Dogs of the Dow, you’re running a concentrated portfolio without doing any of the research that would make it reasonable. And given that the Dow Industrials have only 30 stocks and very little in the way of sector diversification, you’re starting with a limited pool.

The Dow is a terrible index that is tracked today only because of name recognition and tradition. Were Charles Dow alive and working on Wall Street today, the Dow Jones Industrial Average would not be what he would have come up with. It is a relic of an age before computers, and any professional using it today for anything other than elevator conversation out to have his licenses revoked and be publicly flogged.

Look at what you would have had to choose from in 2008. The highest Dow yielders going into that year included General Motors ($GM), Citigroup ($C), JPMorgan Chase ($JPM) and General Electric ($GE). Not exactly what I would have considered a conservative value investor’s dream portfolio given that General Motors went bankrupt and the other three had to seek bailouts.

This brings me to the focus of this article, the ALPS Sector Dividend Dogs ETF ($SDOG), which began trading late last month.

SDOG takes the spirit of the Dogs of the Dow strategy but addresses it major flaws. Rather than use the Dow as its pool, it uses the much larger S&P 500. But in my view, the biggest selling point is its sector diversification. SDOG holds the five highest-yielding stocks in each of the S&P 500’s ten industrial sectors for a total of 50 stocks. In other words, it will hold the five highest-yielding telecom companies, the five highest-yielding consumer discretionary companies, the five highest-yielding financials, etc.

So, rather than get the 50 highest yielding stocks in the S&P 500, which could be concentrated in a few problem-plagued sectors, your risk is spread evenly across all major sectors. You avoid any sector biases. For a low-maintenance mechanical strategy, this is attractive.

SDOG is too new to have a dividend history, but its underlying index, the S-Network Sector Dividend Dogs Index, has a yield of 5.0%. Allowing for the 0.40% in management fees that ALPS collects and some amount of slippage would put the ETF’s dividend yield at around 4.5%. That’s higher than the yield on the popular iShares Dow Jones Select Dividend ETF ($DVY), which yields 3.5%, and more than double the yield of the S&P 500.

A few caveats are in order here. SDOG is a value strategy, and as such it should underperform the market during strong bull markets. Its emphasis is also entirely on current income; there is no screening criteria for dividend sustainability or for dividend growth. This puts it in stark contrast to, say, the Vanguard Dividend Appreciation ETF ($VIG), which has a low current yield but holds companies with a long history of raising their dividends.

As far as purely mechanical strategies go, I like SDOG as a long-term holding. Its high current yield is attractive, as is its strong value tilt. But for long-term growth, I expect VIG to offer better returns. Investors should be able to find a place for both in a balanced ETF portfolio.

Disclosures: Sizemore Capital is long DVY and VIG

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Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Jeremy Grantham’s Top 5 Dividend Stocks

If you don’t know who Jeremy Grantham is, you should.  In fact, once you finish reading this article, you should drop whatever else you are doing, go to his website, and read his latest quarterly letter.  Make it a habit to read every quarterly letter as they come out; you’ll be a better investor for it.  (While you’re at it, make it a habit to read his colleague James Montier’s work as well; Montier’s writing on behavioral investing  is some of the most insightful I’ve ever seen.)

Grantham is the chief investment strategist of Grantham Mayo Van Otterloo (GMO), an investments firm with more than $100 billion under management.  He’s also one of those rare managers who is not afraid to be a voice in the wilderness.  Virtually alone among large money managers, Grantham steadfastly refused to get caught up in the 1990s tech bubble.  His principled stand lost him nearly half his assets under management due to client defections, but those that stuck with him did well in the bear market that followed.

A decade later, he voiced concerns again about bubbles forming in the real estate and financial sectors…and we all know how those turned out.

But lest anyone accuse him of being  a “perma bear,” Grantham was pounding his fist on the table immediately after the 2008 meltdown telling investors to buy when everyone else was too terrified to move.  

Suffice it to say, this is a guy who has had a good grasp on the market conditions of the past several years.  He’s someone you ought to listen to.

With that said, let’s take a look at Mr. Grantham’s top five stock holdings as of his firm’s SEC filings, as reported by GuruFocus.

Stock

Ticker

Current Price

Dividend Yield

Microsoft

MSFT

$30.21

2.7%

Johnson & Johnson

JNJ

$69.03

3.6%

Philip Morris International

PM

$88.99

3.4%

Pfizer

PFE

$23.60

3.8%

Coca-Cola

KO

$76.91

2.7%

 As a demanding value investor, it is not at all surprising to see that all five of Grantham’s top holdings pay dividends far in excess of the market average of approximately 2%. 

It’s also not at all surprising to see that his holdings are serial dividend growers.  After all, for long-term investors, the dividend today is far less important than the dividend 5 years from now.

Coca-Cola ($KO) is the second-largest holding of my favorite ETF, the Vanguard Dividend Appreciation ETF ($VIG), and Microsoft ($MSFT) and Philip Morris International  ($PM) will likely be holdings as well once they meet the time requirements. (In order to be included in the ETF’s underlying index, a stock must have a minimum of ten consecutive years of dividend increases.  Microsoft started paying a dividend in 2003, and Philip Morris International was spun off from parent Altria less than four years ago.)

The real king of dividend growers is Johnson & Johnson ($JNJ), however.   This iconic maker of Band-Aids, Tylenol, Listerine, and too many other health and pharmaceutical products to list has raised its dividend for an astonishing 49 consecutive years. 

The last year in which Johnson & Johnson failed to raise its dividend, John F. Kennedy was the President of the United States.  Stop and think about that for a minute. 

The only stock in Grantham’s top five that has cut its dividend in recent years is Big Pharma giant Pfizer ($PFE), which has been hard hit by the patent expirations and competitive forces that have affected its rivals. 

Big Pharma has done quite nicely in 2012, however, and Pfizer currently trades near its 52-week highs. 

There are no guarantees that owning a basket of Mr. Grantham’s largest stock holdings will beat the market, of course.  There are plenty of years in which his portfolios underperform the market by a wide margin, particularly “risk on” years in which investors throw risk tolerance to the wind.

Still, if you are looking for a portfolio of solid dividend payers for steady, consistent returns, Mr. Grantham’s stocks are worth a good look.

Disclosures: Sizemore Capital is long MSFT, JNJ and VIG.  Sizemore Capital recently sold its holdings of PM.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Comparing Dividend ETFs

I like ETFs as an investment vehicle.  And I love dividends as a source of investment return.

So, one might draw the conclusion that I was favorably disposed towards dividend ETFs, and indeed I am (see “Dividend ETFs for Growth and Income”).

Today, I’m going to take a look at one relatively new entrant in what has become a bit of a crowded fields: the iShares High Dividend Equity Fund ($HDV), which tracks the Morningstar Dividend Yield Focus Index.

To meet Morningstar’s criteria for index membership, companies must have a Morningstar Economic Moat rating of narrow or wide and have a Morningstar Distance to Default score in the top 50% of eligible dividend-paying companies.  The index is then composed of the top 75 companies by dividend yield that meet these criteria.

This requires a little explaining.  Warren Buffett has spoken often of preferring companies with economic “moats” around them that make a challenge from a would-be competitor a challenge.  Coca-Cola’s ($KO) unmistakable brand would be a good example, as would Microsoft’s ($MSFT) domination of the personal computer platform through its Windows operating system and Office productivity software. Not even mighty Apple ($AAPL) has been able to scale Microsoft’s moats in its core areas of expertise.

Morningstar has built upon this “moat” concept, defining it as “the sustainability of a company’s future economic profits.”  In order to earn a narrow or wide moat rating, a company must have “the prospect of earning above average returns on capital, and some competitive edge that prevents these returns from quickly eroding.” Obviously, there is a degree of subjectivity involved, as this is not a numeric value that can be found in a stock screener.  And to be sure, not all moats prove to be unassailable (consider that Research in Motion’s ($RIMM) enterprise email and messaging ecosystem might have been considered a moat just a few years ago). 

Morningstar’s Distance to Default Score is more quantitative yet also a little more esoteric.  It uses option pricing theory to evaluate the risk of a company becoming insolvent. 

While I like Morningstar’s focus on moats, I’m a little more skeptical on its distance to default metric.  Yes, the metric would probably do a decent job most of the time of preventing you from buying a high-yielding stock that was on the verge of slashing its dividend en route to going bust.  Yet option pricing theory would have done little to foresee an event like the 2008 meltdown until it was far too late, and it certainly didn’t prevent Long-Term Capital Management from blowing up a decade before.

HDV is a sibling to the older and better-known iShares Dow Jones Select Dividend ETF ($DVY), which I highlighted in the article I referenced above and which I use in my Covestor Strategic Growth Allocation.  DVY is the granddaddy of all dividend ETFs, and tends to be heavily weighted towards utilities (currently 31% of the ETF) and consumer staples (16%).

HDV holds a much smaller allocation to utilities (just 14%), but has large allocations to health care (29%) and consumer staples (24%).

According to iShares, both ETFs currently yield 3.6%, and both have expense ratios of 0.4%.  Over time, I would expect DVY to sport a higher current yield, though I would expect HDV to offer better potential for capital gains.  In the short-to-medium term, the decision of one over the other is essentially a matter of sector preference.

For longer-term capital gains, my preference remains the Vanguard Dividend Appreciation ETF ($VIG).  Though it currently yields no more than the broader S&P 500, the ETF is comprised of companies that have raised their dividends every year for the past 10 years.  And while there is no guarantee that they will continue to raise their dividends going forward, the 10-year criteria ensures that you own a portfolio of some of the highest-quality growth companies in the world.  The dividend criteria is also more objective than Morningstar’s moat rating, which depends on the judgment of Morningstar’s analysts.

With that said, any of the ETFs mentioned in this article could be considered as long-term holdings for investor portfolios.  But investors willing to do a little research on their own should eschew buying the ETFs and should instead use their holdings as a convenient stock screener.  Pick and choose the companies you like best from each.  Coca-Cola—which happens to be one of Warren Buffett’s all-time favorites—happens to be a holding of all three ETFs.

Disclosures: DVY, MSFT and VIG are held by Sizemore Capital clients. This article first appeared on MarketWatch.

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Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Philip Morris International: A Dividend Stock Best Avoided

Nothing is more detrimental to the long-term viability of an investment theme than its own success.  In the often circular logic that defines the market, profitable trades can only remain so as long as they are unpopular.  Once they are embraced by the investing public, prices have generally risen to a point that would make the trade unattractive to its original value-focused adherents.

It is thus with great sadness that I must recommend readers sell their shares of Philip Morris International (NYSE: $PM).  At current prices, this is a dividend stock best avoided.

When Altria (NYSE:$MO) spun off its international tobacco businesses and formed Philip Morris International in 2008, it was about as close as you could get to the perfect stock.  You had all of the standard bullish arguments for tobacco—recession-resistant demand, an addicted customer base, low marketing costs, high cash flows, etc.—but without the threat of crippling lawsuits from the U.S. tort system.

Philip Morris International was also uniquely positioned to take advantage of rising incomes in the developed world.  As consumers in key emerging markets such as China traded up from lower-quality domestic brands, the maker of Marlboro was uniquely positioned to benefit, and still is.

And finally—and perhaps most importantly—Philip Morris International was a dividend-producing powerhouse at a time when decent yields were hard to come by. 

It was the convergence of all of my favorite investment themes in one stock: a high-dividend sin stock with emerging market growth and brand cachet!

But no matter how great an investment looks, your long-term success is ultimately dependent on the price you pay.  And the reason that tobacco stocks have been such great wealth-creation vehicles in recent decades is because they have been perpetually priced as high-dividend value stocks (see “The Price of Sin”).

Let’s face it.  Tobacco is not a growth industry, not even in most emerging markets.  While smoking remains popular in many, market penetration hit the high-water mark a long time ago.  And as health awareness rises with incomes, the best the industry can hope for is gentle decline.

Knowing this, long-term investors tend to by tobacco stocks for one and only reason—the high dividends they offer.

Yet consider how Philip Morris International’s dividend stacks up with other consumer-oriented companies with large footprints in emerging markets.

Company

Ticker

Dividend Yield

Forward P/E

Johnson & Johnson

JNJ

3.7%

12.1

Philip Morris International

PM

3.6%

14.8

Procter & Gamble

PG

3.8%

15.1

Unilever

UL

3.9%

13.7

 At current prices, investors can get a higher dividend yield in Johnson & Johnson (NYSE:$JNJ), Procter & Gamble (NYSE:$PG) and Unilever (NYSE:$UL), and Philip Morris International trades at a higher P/E ratio than all but Procter & Gamble.  And while each of these three examples has had its share of problems in recent years, the longer-term prospects for all are vastly superior to those for Philip Morris International.

Let me put it to you like this: 50 years from now, I suspect that Philip Morris International will still be selling plenty of cigarettes.  But I’m betting that Johnson & Johnson, Procter & Gamble, and Unilever are selling a lot more Band-Aids, razor blades, and shower gel, respectively.  I’m grossly oversimplifying the businesses of all three of these companies, but my point stands: Philip Morris International is only attractive if it is priced at a significant discount to mainstream consumer products companies like the ones mentioned in this article.

This condition does not hold today, which is why I must regrettably make Philip Morris International a “sell.” 

Investors looking for income these days still have plenty of decent options, even if reliable choices from years past are no longer as attractive as they might been.  Many oil and gas master limited partnerships offer attractive yields, as do select specialty REITs.  Telecom and utilities stocks are also attractive.  But at current prices, investors might find Philip Morris International’s stock as dangerous as its products.

Disclosures: Sizemore Capital is long MO, PG, JNJ and UL

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Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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