Is the High-Yield Bubble About to Burst?

01/04/2012 9:45 am EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

Investors have been piling into income stocks, but this rush to safety may be overdone, which is why Josh Peters of Morningstar DividendInvestor did some research. Here are his findings.

Could high-quality, high-yielding stocks be getting ahead of themselves? I haven’t noticed many other Wall
Street observers asking this question in the past few months, but I don’t mind being among the first.

The Morningstar Dividend Leaders Index of high-yielding stocks has returned 10.1% to date, while the Dow Jones Select Dividend Index has produced 8%. It’s not hard to find good reasons for this: Interest rates are very low, investors are very nervous about the economy, and defensive, high-yield stocks strike many as a welcome respite.

Of course, our strategy is to acquire and own mostly defensive, high-yielding stocks through all market conditions. Sometimes this will correspond with what’s fashionable, sometimes it definitely won’t, but in any event we stick with the same approach through thick and thin, because we prize the fundamental returns that only large and growing dividends can provide.

So a better question for our purposes might be, are high-payout stocks getting too expensive?

I was a bit surprised to discover that this is not really the case. Using data for the 463 companies in the S&P 500 index that had active Morningstar fair-value estimates as of December 13, the 364 active dividend payers traded at a median 13% discount to fair value, while non-payers were priced at a 15% discount—not a gap large enough to draw firm conclusions from.

I then sorted the 364 payers into deciles by current yield, and while this did reveal a tilt toward dividends, it wasn’t that big. The top decile—stocks that yielded at least 4.6% as of December 13—had a median price/fair value discount of 6%, the second decile (yields over 3.7%) had a 7% discount, and the other eight deciles had discounts between 11% and 22%.

If the economy unexpectedly surges, or the dark clouds over Europe suddenly brighten, lower-yielding cyclical stocks may outperform for a while. But while higher-yielding stocks may be a bit more expensive relative to low and no-yield stocks, we don’t think they’re overpriced on an absolute basis. So I see no reason for long-term investors to hop off the dividend bandwagon.

Promotions and Demotions
The three trades I made in the Builder Portfolio in November all require corresponding changes to the Bellwethers watchlist. Former Bellwether Kinder Morgan (KMI) comes off the list, while the two stocks I sold from the Builder—Bemis (BMS) and McCormick (MKC)—will now be monitored here.

McCormick in particular deserves a slot for what is still an outstanding business. Although I think the stock is a bit richly priced right now, at my buy price of $40 it would again yield more than 3% and become a strong contender for a new Builder stake.

Bemis is a far less likely candidate for some future purchase because of the narrowing of its already-narrow economic moat, but its current yield is high enough and the firm big enough to deserve ongoing coverage.

With two additions and only one natural deletion, one other Bellwether had to go, and that wound up being VF Corporation (VFC). Though its record of dividend growth is nothing to sneeze at, huge gains this year left VF with the lowest yield (2.1%) on the list, making it the least relevant Bellwether for our purposes.

Dividends at Risk
Dividend cuts have been very rare this year—as they usually are—but this month two new names have joined the Payouts in Peril list.

Frontier Communications (FTR) is covered under my general ban on rural telecom carriers, but its 15% yield signals that the market thinks a cut is imminent.

Separately, despite a tantalizing 5.7% yield, I would stay away from Avon (AVP). Though recent earnings have covered dividends with plenty of room to spare, the company is entering an uncertain phase that could involve major restructuring activity and management changes.

More ominously, Avon has offered only a halfhearted defense of its dividend. A cut is not a foregone conclusion, but I don’t care for the elevated level of risk here.

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