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Are Dividends Becoming Too Popular?

Josh Peters, CFA

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.

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Now, if we look at the rest of the dividend-paying universe, those stocks that yield more than zero but less than 4%, 58% of these stocks we think are undervalued relative to our fair value estimates, which are based on our assessment of the company's intrinsic value. So this is telling us that perhaps the market has gotten just a little bit ahead of itself in terms of valuing dividend-paying stocks relative to the stock market as a whole.

Now, how big of a problem is this? Well, if you're continuing to hold dividend-paying stocks as part of a long-term investment strategy, and you've had the opportunity to acquire shares at good prices in years past, I don't think there is anything to worry about. The type of overvaluation we're looking at is not the territory where you typically would want to run for the hills.

At the same time, investing new money at this point in a dividend strategy, I think, has become a little bit tougher. When prices are not that favorable relative to the intrinsic value of the business, relative to the package of dividend, growth, and current yield that will drive your total return in the future, you don't have a lot of room for air. You don't have the margin of safety that Ben Graham preached all those years ago.

So, what might you consider? Well, first, make sure you don't confuse your safe money with your stock market money; no matter how attractive the dividend yields might be on some stocks, even those that have come up from their lows, you don't want to assume that you can get your money back exactly what you put into a stock; over the next couple of years. If interest rates go up, a lot of these stocks could be worth less, even if their dividends are maintained or even continue to grow.

Second and equally as important, you might want to consider rolling money into stocks slowly, dollar cost averaging over a series of months, maybe even a couple of years. I don't think it's necessary to take all of the money that you might eventually want to have invested in dividend-paying stocks, and move it in at a single price point in the market. Give yourself the opportunity to benefit from some variations in prices as time unfolds.

Finally, if you're the kind of investor who isn't all that concerned about needing a big margin of safety, even though I do think it is a good idea, and you'd be willing to pay the kinds of prices in exchange for the dividend yields and total returns that we see from this point going forward, I'd say probably 8% to 10% for the universe of higher-yielding stocks in the U.S., then do yourself a big favor, probably the best favor you can do for yourself at just about any point in the market, stick to the highest-quality names.

I found in the years that I've been managing DividendInvestor that when I relax my standards in pursuit of a bit more yield, a bit more growth or just a cheaper stock, I can wind up getting burned. That's why I like to stick with the best-quality names even if I have to pay a little bit more for them.

Three names that I think are very, very attractive businesses, even if not quite so attractive in terms of their current valuations are Philip Morris International, which owns the Marlboro brand all around the world other than in the United States, recently raised its dividend more than 10%, kind of unusual for a stock that has already been yielding high 4s, even low 5s.

AmeriGas Partners, which is the nation's largest distributor of propane, a very good business, doesn't grow a whole lot, but the companies tend to have very good pricing power, sticky customer relationships, and it's a wonderful cash-cow business, in this case with a 6.3% yield.

And Waste Management, one of the unsung heroes as far as I'm concerned from the industrial sector, that has deployed a tremendous amount of cash to shareholders' direct benefit through dividends and share repurchases, and hasn't gotten a whole lot of credit for it.

It's also a very good business, owning landfills, practically a monopoly, tends to lead to pretty high returns on invested capital. All three of these businesses have attributes that I like as businesses. I don't like their stock prices quite so much. I'd rather buy them cheaply, especially in case I happen to be making a mistake with regard to my expectations. But these are the first names that you'd want to consider I think in a market downturn, and if you are willing to pay that extra dollar or two in order to get invested more quickly, these would be some names that I would find relatively attractive.

So making investment decisions in this environment isn't always easy. Stocks aren't necessarily cheap; especially the kinds that pay high dividends that so many people are finding attractive these days. But I think it's a good opportunity to take the long-term perspective and to think like a business owner, think about what you're really getting in return for your capital, and perhaps put a little patience and time on your side as you look to migrate your portfolio toward more income over time.

With that, I'd like to thank you very much for watching. This has been Josh Peters, editor of Morningstar DividendInvestor.