Are We In A Dividend Stock Bubble? Nope.

Author: Charles Sizemore

Covestor models: Dividend Growth, Strategic Growth Allocation, Sizemore Investment Letter, Tactical ETF

No, Virginia. There is no bubble in dividend-paying stocks.

This is not to say that defensive sectors of the market are not overpriced compared to more cyclical sectors, or that some investors are chasing yields where they can find them to do better than the paltry rate on bonds.

Dividend-paying stocks have certainly outperformed their non-dividend-paying brethren in 2012. Some dividend-focused indexes —such as the S&P Dividend Aristocrats — are near all-time highs even as 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.

That's not true.

Let's start with that most iconic of American companies Coca-Cola (KO). Coke is a special case. It is both a high current dividend-paying stock and one with a history of rising dividends.

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 my Strategic Growth Allocation and my Tactical ETFinvestment models.

Coke trades for 17 times estimated 2013 earnings. OK, that is significantly more expensive than the 13 times earnings of the broader S&P 500. But for a company of Coke's quality and safety, 17 times earnings would hardly seem excessive.

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, that hardly suggests nosebleed valuations.

Moreover, the investors piling into those stocks are not doing so in hopes of getting rich quick. We are not seeing 1990s tech mania or 2000s-era condo flipping. Investors' goals are 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.

That is 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. That compares to a historical average of 52%.

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.

It should be welcomed.

Disclosure: Long DVY, JNJ, PG, VIG, and WMT

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