Dividend stocks are dirt cheap. It may be time to back up the truck.

By Philip van Doorn

Dividend stocks' yields are the highest, relative to the S&P 500, that a veteran fund manager has ever seen.

The stock market always overreacts, and this year it seems as if investors believe dividend stocks have become toxic. But a look at yields on quality dividend stocks relative to the market underlines what may be an excellent opportunity for long-term investors to pursue growth with an income stream that builds up over the years.

The current environment, in which you can get a yield of more than 5% yield on your cash at a bank or lock in a yield of 4.57% on a10-year U.S. Treasury note BX:TMUBMUSD10Y or close to 5% on a 20-year Treasury bond BX:TMUBMUSD20Y seems to have made some investors forget two things: A stock's dividend payout can rise over the long term, and so can it is price.

It is never fun to see your portfolio underperform during a broad market swing. And people have a tendency to prefer jumping on a trend hoping to keep riding it, rather than taking advantage of opportunities brought about by price declines. We may be at such a moment for quality dividend stocks, based on their yields relative to that of the benchmark S&P 500 SPX.

Drew Justman of Madison Funds explained during an interview with MarketWatch how he and John Brown, who co-manage the Madison Dividend Income Fund, BHBFX MDMIX and the new Madison Dividend Value ETF DIVL, use relative dividend yields as part of their screening process for stocks. He said he has never seen such yields, when compared with that of the broad market, during 20 years of work as a securities analyst and portfolio manager.

Dividend stocks are down

Before diving in, we can illustrate the market's current loathing of dividend stocks by comparing the performance of the Schwab U.S. Equity ETF SCHD, which tracks the Dow Jones U.S. Dividend 100 Index, with that of the SPDR S&P 500 ETF Trust SPY. Let's look at a total return chart (with dividends reinvested) starting at the end of 2021, since the Federal Reserve started its cycle of interest rate increases in March 2022:

The Dow Jones U.S. Dividend 100 Index is made up of "high-dividend-yielding stocks in the U.S. with a record of consistently paying dividends, selected for fundamental strength relative to their peers, based on financial ratios," according to S&P Dow Jones Indices.

The end results for the two ETFs from the end of 2021 through Tuesday are similar. But you can see how the performance pattern has been different, with the dividend stocks holding up well during the stock market's reaction to the Fed's move last year, but trailing the market's recovery as yields on CDs and bonds have become so much more attractive this year. Let's break down the performance since the end of 2021, this time bringing in the Madison Dividend Income Fund's Class Y and Class I shares:

   Fund                                      2023 return  2022 return  Return since the end of 2021 
   SPDR S&P 500 ETF Trust                          14.9%       -18.2%                         -6.0% 
   Schwab U.S. Dividend Equity ETF                 -3.8%        -3.2%                         -6.9% 
   Madison Dividend Income Fund -- Class Y          -4.7%        -5.4%                         -9.9% 
   Madison Dividend Income Fund -- Class I          -4.7%        -5.3%                         -9.7% 
                                                                                    Source: FactSet 

Dividend stocks held up well during 2022, as the S&P 500 fell more than 18%. But they have been left behind during this year's rally.

The Madison Dividend Income Fund was established in 1986. The Class Y shares have annual expenses of 0.91% of assets under management and are rated three stars (out of five) within Morningstar's "Large Value" fund category. The Class I shares have only been available since 2020. They have a lower expense ratio of 0.81% and are distributed through investment advisers or through platforms such as Schwab, which charges a $50 fee to buy Class I shares.

The opportunity -- high relative yields

The Madison Dividend Income Fund holds 40 stocks. Justman explained that when he and Brown select stocks for the fund their investible universe begins with the components of the Russell 1000 Index RUT, which is made up of the largest 1,000 companies by market capitalization listed on U.S. exchanges. Their first cut narrows the list to about 225 stocks with dividend yields of at least 1.1 times that of the index.

The Madison team calculates a stock's relative dividend yield by dividing its yield by that of the S&P 500. Let's do that for the Schwab U.S. Equity ETF SCHD (because it tracks the Dow Jones U.S. Dividend 100 Index) to illustrate the opportunity that Justman highlighted:

   Index or ETF                       Dividend yield  5-year Avg. yield   10-year Avg. yield   15-year Avg. yield   Relative yield  5-year Avg. relative yield   10-year Avg. relative yield   15-year Avg. relative yield 
   Schwab U.S. Dividend Equity ETF             3.99%               3.41%                3.20%                3.16%             2.6                          2.1                           1.8                           1.6 
   S&P 500                                     1.55%               1.62%                1.79%                1.92% 
                                                                                                                                                                                                            Source: FactSet 

The Schwab U.S. Equity ETF's relative yield is 2.6 -- that is, its dividend yield is 2.6 times that of the S&P 500, which is much higher than the long-term averages going back 15 years. If we went back 20 years, the average relative yield would be 1.7.

Examples of high-quality stocks with high relative dividend yields

After narrowing down the Russell 1000 to about 225 stocks with relative dividend yields of at least 1.1, Justman and Brown cut further to about 80 companies with a long history of raising dividends and with strong balance sheets, before moving further through a deeper analysis to arrive at a portfolio of about 40 stocks.

When asked about oil companies and others that pay fixed quarterly dividends plus variable dividends, he said, "We try to reach out to the company and get an estimate of special dividends and try to factor that in." Two examples of companies held by the fund that pay variable dividends are ConocoPhillips (COP) and EOG Resources Inc. (EOG).

Since the balance-sheet requirement is subjective "almost all fund holdings are investment-grade rated," Justman said. That refers to credit ratings by Standard & Poor's, Moody's Investors Service or Fitch Ratings. He went further, saying about 80% of the fund's holdings were rated "A-minus or better." BBB- is the lowest investment-grade rating from S&P. Fidelity breaks down the credit agencies' ratings hierarchy.

Justman named nine stocks held by the fund as good examples of quality companies with high relative yields to the S&P 500:

   Company                              Ticker   Dividend yield  Relative yield  2023 return  2022 return  Return since the end of 2021 
   CME Group Inc. Class A                CME              2.04%             1.3          31%         -23%                            1% 
   Home Depot, Inc.                       HD              2.79%             1.8          -3%         -22%                          -25% 
   Lowe's Cos., Inc.                     LOW              2.17%             1.4           3%         -21%                          -19% 
   Morgan Stanley                         MS              4.24%             2.7          -3%         -10%                          -13% 
   U.S. Bancorp                          USB              5.89%             3.8         -22%         -19%                          -37% 
   Medtronic PLC                         MDT              3.62%             2.3           1%         -23%                          -22% 
   Texas Instruments Inc.                TXN              3.30%             2.1          -3%         -10%                          -12% 
   United Parcel Service Inc. Class B    UPS              4.17%             2.7          -8%         -16%                          -23% 
   Union Pacific Corp.                   UNP              2.52%             1.6           2%         -16%                          -15% 
                                                                                                                        Source: FactSet 

Click on the tickers for more about each company, fund or index.

Click here for Tomi Kilgore's detailed guide to the wealth of information available for free on the MarketWatch quote page.

Now let's see how these companies have grown their dividend payouts over the past five years. Leaving the companies in the same order, here are compound annual growth rates (CAGR) for dividends.

Before showing this next set of data, let's work through one example among the nine stocks:

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