Dividend Stocks: Buoyant or Bubble?

02/29/2012 10:30 am EST

Focus: INCOME

John Heinzl

Reporter and Columnist, GlobeInvestor.com

They are usually solid, profitable companies with a long history of rewarding shareholders, but you decide, writes John Heinzl, reporter and columnist for Globe Investor.

You've heard about housing bubbles, commodity bubbles, and the Internet bubble. Are we in the midst of a dividend bubble?

After the big run-up in dividend stocks over the past couple of years, a few people have started to throw around the "b" word. They argue that with bond yields at historic lows, income-starved investors have rushed recklessly into dividend stocks, pushing prices to dangerously high levels.

Some are even comparing it—albeit loosely—to the subprime bond crisis. Yikes!

"Blue-chip dividend stocks are not subprime bonds. But there's an argument to make that, just as investors ran blindly into subprime bonds five years ago in search of yield, they're running blindly, carelessly into dividend stocks today," Morgan Housel, a contributor to the Motley Fool investment Web site, wrote recently.

It's true that dividend stocks have become enormously popular with investors, and valuations in some cases may have become stretched. Price-to-earnings multiples for many classic dividend payers—pipelines, utilities, and real estate investment trusts, for example—have jumped, and yields have plunged to the lowest in years.

There's also been an explosion of dividend-oriented products—particularly exchange traded funds—to meet the growing demand for income.

But it's a gigantic leap to argue that we are therefore in a dividend bubble. We're not, and here's why.

First, let's define what a bubble is. Most investment bubbles, or manias, share several characteristics.

They are usually speculative in nature, meaning that investors buy with the expectation that they will be able to flip the asset for a large capital gain. Demand is often fueled by leverage, which magnifies price increases, which in turn draws in more buyers.

As investors become increasingly euphoric, they ignore risks and throw traditional valuation methods out the window to justify the ascent in prices. There is often talk of a "new era"—a feeling that prices will rise forever.

That never happens, of course, as anyone who bought a condo in Florida or invested in Pets.com can tell you. The hallmark of all bubbles is that they eventually pop, causing massive losses to speculators who didn't get out in time.

Dividend stocks are different. They are typically solid, profitable companies with a long history of rewarding shareholders.

Most dividend investors I know aren't speculators, and they don't buy on margin. They buy dividend stocks, not to flip to a greater fool, but to hold in their retirement portfolios. They often have investing horizons measured in decades, over which time they expect their dividends to grow.

What's more, dividend stocks have a self-correcting mechanism built in. If the price rises, the yield falls, making the shares less attractive to income investors. That—theoretically, at least—should keep prices from getting too out of line.

Is it possible to get burned by dividend stocks? You bet it is. Yellow Media (Toronto: YLO) and Manulife Financial (MFC) are two high-profile Canadian examples, but these companies were plagued by specific business problems, not bubble-like valuations.

In fact, far from being in a bubble, there's little evidence that dividend stocks are even overvalued as a group. The yield on the S&P/TSX composite index is about 2.6%, which is higher than the average of about 2.4% over the last decade.

If we were in a bubble, you'd expect prices to have risen so high that the yield would be a lot lower than that. Similarly, the yield on the S&P 500 is 2%, which matches the yield of the past ten years.

Granted, dividend yields used to be higher. Until the 1970s, S&P 500 companies paid out about 50% of their profits as dividends, but the payout ratio has fallen to about 30%.

Given the more than $1 trillion of cash sitting on corporate balance sheets, however, the payout ratio will likely rise as companies return more cash to income-hungry shareholders.

That's one more reason that talk of a dividend bubble is just hot air.

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