Paying More for Dividends
Long favored by risk-averse retirees, dividend-paying stocks have been attracting investors of all stripes lately for their high yields and market-trumping returns. But as their popularity grows, even some advisers are starting to ask: Are dividend payers getting too pricey?
Investors poured $31.3 billion into mutual funds and exchange-traded funds that invest in dividend payers last year, nearly five times the amount in 2010, according to researcher Lipper Inc. By comparison, all equity funds and ETFs lost $33.5 billion. The allure? Experts say income-seeking investors have turned to these stocks and funds for their yields, which have trumped those of 10-year Treasurys. Others, they say, were surely chasing performance: Stocks in the Standard & Poor’s 500 index that pay dividends posted a 1.4% total return in 2011, while non-payers fell 7.6%.
That rush, however, is making many dividend payers more expensive, say advisers. Historically, dividend stocks trade at lower price-to-earnings ratios, with the expectation that they’ll grow less quickly than other stocks. While that’s still the case, the gap between payers and non-payers is shrinking: At the end of 2010, the average price-to-earnings ratio of non-payers in the S&P 500 was 37% higher than the average P/E for payers; today it’s 33%. Die-hard dividend devotees are now seeing a lot more short-term traders crowding into their corner of the market. “I’m as big a fan of dividend stocks as I ever have been, but when everybody else starts talking your strategy, you have to be scared,” says Josh Peters, the editor of Morningstar’s DividendInvestor newsletter.
Indeed, analysts say that these higher prices mean that last year’s strong outperformance by dividend stocks might not be repeated. In the utilities sector, for example, “when you start looking at high double digit P/Es, there’s not much room left for gains,” Peters says. Plus, in a rising stock market, these historically slow-and-steady stocks would take a back seat to higher-risk, higher-return growth stocks. “If interest rates go up or the stock market goes on some kind of a speculative binge, then these stocks will get left in the dust,” Peters says.
Even fans note that the growing popularity of dividend stocks’ has started pushing down yields in some high-flying sectors like utilities and tobacco (as stock prices rise, yields fall). Shares of Philip Morris, for example, jumped 35% in 2011, but the stock saw its yield shrink from 4.2% to 3.6%. Likewise, yields for Duke Energy Corporation (DUK: 21.23, -0.07, -0.33%) have fallen from about 5.4% to 4.5% over the past year as shares gained 20%.
Despite these drawbacks, investing pros say that dividend stocks still have plenty to offer long-term investors. Because they tend to be less volatile than non-payers, they tend to lag in a bull market, but hold up better when markets falter, says Howard Silverblatt, the senior index analyst at Standard & Poor’s. “Basically, the dividend acts as an anchor holding the stock in place,” he says. And because many companies increased their dividends over the course of 2011, dividend investors will be getting more income through 2012. “Unless companies cut [their dividends], you almost have to get a double-digit increase this year,” Silverblatt says.
To avoid overpaying for income, advisers say investors should focus on companies that are still growing their dividends, instead of looking for the highest current yields. “Dividend growers are great inflation protection because that yield is increasing every year,” says Steven Roge, a portfolio manager at R.W. Roge & Company. And if the yield is rising, he says the underlying fundamentals of the company are likely improving, too. Roge recommends dividend-growing consumer staples stocks like PepsiCo (PEP: 65.68, -0.60, -0.91%), whose payout has increased by about 22% since 2008, or spice-maker McCormick & Company (MKC: 51.21, -0.30, -0.58%), whose payout is up about 27% in that time.