Equity markets have been regularly hitting all-time highs, and stocks are looking more and more overbought. I've been expecting a correction for a few weeks, but so far no dice -- unless we're seeing the beginning of one now. Regardless of where you think the market is going, you should have some money in equities -- I'd say 40% to 50% of your holdings. And much of that should be in dividend-paying stocks, despite their big run.
For average investors with a moderate risk tolerance, dividend-paying stocks are still the best combination of income and potential capital gains. And, to paraphrase Winston Churchill on democracy, all the other alternatives are so much worse. Take bonds, for instance. The 10-year Treasury note is yielding 2%. High-yield bonds recently yielded below 5%, their lowest ever, and Treasury Inflation Protected Securities (TIPS) guarantee negative returns for the next 15 years.
Yet, after a 30-year bull market in which the 10-year note's yield has plummeted from 15.8% in 1981 (and in which 30-year Treasury bonds outperformed the S&P 500), retail investors continue to pour money into taxable bond funds -- $1 trillion from 2007 to 2012, and nearly $80 billion thus far in 2013, according to the Investment Company Institute. Meanwhile, companies in the S&P 500 paid out only 36% of their profits in dividends, "a near-historic low," said Jeremy Siegel of The Wharton School. That compares with a payout ratio in the mid-40s from the 1970s to the 1990s, giving companies "plenty of room to raise dividends," Siegel said in Knowledge@Wharton.
Michael Farr, owner of Farr, Miller, & Washington, an investment firm in Washington, D.C., has favored big blue-chip dividend payers for years. "Income-producing shares have far outpaced their low- and no-dividend brothers and sisters significantly over the last 10 years, as interest rates have fallen from 6% to below 2% on the ten-year Treasury," he said. Yet he called the interest-rate decline "a generational tailwind that may continue for a while, but is not likely to be repeated in the next few decades."
He views bonds as particularly vulnerable. "We've had a remarkable decade ... of a bond-market rally, and you could look at the last few years as the blow-off stage of the rally," he continued. "It has been classic exuberance." For instance, a 6.75% 30-year Treasury bond maturing in 2026 is trading at a mind-boggling 50% premium to par value. That's nosebleed territory.
At the same time, Farr acknowledged that "we are seeing the beginning of the separation between share prices and fundamentals. ... The further you look out, the more modest the [earnings] outlook from the CEOs," he said. "Real organic growth ... is not really there."
Earnings May Not Be Driving the Market
In fact, earnings may not be driving this market at all. "We have seen the markets increase something like 45% in the last 24 months," he said, but estimates that 70% to 80% of that move was due to the expansion of price-to-earnings multiples, not earnings growth. That makes dividend-paying stocks more appealing, he said. "If you really don't know if the next 20% move is up or down over the next 12 to 24 months ... then what am I going to own?"
Dividend-paying stocks of companies with established businesses, a strong competitive position, and solid cash flow, such as JPMorgan Chase (JPM). Its stock has risen 62% over the past year, and at around $54 Wednesday it traded near 12-year highs. But at less than 10 times trailing 12 months earnings, Farr said, "it's not particularly expensive." Its dividend yield is 2.9%.
JPMorgan is a massive global financial services company, with assets of $2.4 trillion and a market capitalization over $200 billion. "I think they'll be able to grow earnings at 10% to 11% on average over the next five years," Farr said. "This is a huge, diversified financial services company ... and I think management's excellent," he added. JPMorgan survived the financial crisis relatively well under the leadership of Jamie Dimon, but he took a big hit in last year's London Whale scandal, which cost the bank at least $6 billion in trading losses. Still, his victory in a shareholder vote at Tuesday's annual meeting means Dimon, like the bank, is "too big to fail," said Farr.
Microsoft (MSFT) is another Farr favorite. It's gained 31.6% in 2013, despite tepid reception of the Windows phone and the failure of the new Windows 8 operating system to catch on. But Farr said "they have strength in a lot of areas -- business and server tools. I think earnings are going to grow in the high single digits -- 8% to 9%." Microsoft has market capitalization of $290 billion, and changes hands at 11 times next year's earnings. It also yields 2.6% and has $5 a share in cash, he said.
Energy giant Chevron (CVX) has "invested a whole lot of money in infrastructure" over the past few years, and now "they project they can grow production by 3.5% per year to 3.3 million barrels a day in 2017," Farr said. Changing hands at less than 10 times trailing 12 months earnings, the stock trades at around $125, near its all-time high. Farr expects it to grow earnings per share by 4% to 6% annually, while it yields 3.2%. He's looking for around a 9% total return a year.
All these stocks are close to multi-year highs, so I'd wait for a pullback to buy them -- and only as a small part of a well-diversified portfolio. If you prefer funds, you might consider the iShares Select Dividend Index ETF (DVY), which yields about 3.4%, or the actively managed T. Rowe Price Equity Income (PRFDX), which yields 2% and has been managed by T. Rowe Price chairman Brian Rogers since 1985. Neither my family nor I own any of these stocks or funds.