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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