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By Josh Peters, CFA | 10-01-2010 06:00 AM

Are Dividends Becoming Too Popular?

The market has gotten just a little bit ahead of itself in terms of valuing dividend-paying stocks, says Morningstar's Josh Peters. Here are three tips for dividend investors today.

Josh Peters: Hello. I am Josh Peters, editor of Morningstar DividendInvestor.

Could it be that dividends are becoming too popular?

This might not sound like a question that the editor of a dividend investing newsletter would necessarily want to ask aloud, but I think it's very important that investors always keep the most critical factors in mind, total return, when they are making investment decisions for their portfolio, and nothing, nothing, is going to affect your total return more than the price that you've paid for your stocks.

So let's take a quick look at some numbers.

If we look at the performance of stocks in 2010 thus far, which really hasn't been that great of a year, we see that dividend-paying stocks as measured by the two indexes you see on the screen have been outperforming. In fact, the Harvest Portfolio, which is one of the two model portfolios that I manage in DividendInvestor, has actually performed very well in this environment.

Part of that I'd like to think has to do with the fact that dividend-paying stocks are simply better companies, and that investors are starting to realize that after about 15-, 20-year period of placing primary emphasis on capital gains and growth instead of dividends, that perhaps a good bird in the hand is worth two or more in the bush.

On the other hand of the spectrum, we have to consider what's happened to interest rates in this environment. Where've they gone? Nothing but down. Seeing a 10-year Treasury bond paying only 2.5% and seeing many shorter-term money market funds and CDs paying far less even than that, is certainly chasing some money into the stock market, especially dividend-paying stocks, that might not otherwise be there.

What kind of effect does this have on price and future total return? Well, it has made prices go up, and as prices go up, future total return potential tends to come down. If we look at Morningstar's coverage of domestic stocks, we find that about 156 stocks are yielding 4% or more as of Sept. 27, but 55% of these stocks are actually overvalued. They are not massively overvalued. We don't have very many 1-star stocks in this group, but only three actually come in with our 5 Star rating; undervalued enough to have our 5 Star rating.Read Full Transcript

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