The Wall Street Journal recently published an article titled "Dividend Stocks Become the Heroes" that discussed the relationship between the popularity of dividend-based investing and the evaluations of mature, large-cap American firms that pay out dividends. Jonathan Cheng pointed out that investors starved for income and wary of risk have turned to strong dividend-payers in what he considers a flight to safety, and he questions whether this adds a "bubble" element to dividend-growth investing. To get a quick snapshot of the debate, see this quote below:
Skeptics contend that dividend-rich stocks aren't as safe as they look. The recent run-up is unsustainable, these doubters say, especially if economic conditions improve, which could cause investors to switch to high-growth companies that tend to pay lower or no dividends…In the first half of the 20th century, companies had to pay richer dividends on stocks than on their bonds in order to compensate investors for the higher risk of holding equity. Over time, high-dividend stocks have gotten less attention from investors than growth stocks, except for scurries during periods of economic stress. High-dividend companies have typically seen their price-to-earnings ratios trade 20% or more lower than non-dividend-paying shares over the past three decades, according to Alliance Bernstein. This year, though, valuations on dividend-hefty shares caught up with their no-dividend peers for the first time since the 1970s.
Sure, we all know that anytime someone speaks in generalities, it creates a desire for someone to trying and point out an exception. However, in the case of dividend-focused stocks, I think it's best to speak in terms of an individual stock basis. Sure, we can say that most dividend stocks like Johnson & Johnson (JNJ) and Procter & Gamble (PG) were overpriced in 2000 when they, along with most of the large-cap market, were trading at 35-50x earnings.
We can also point out how late 2008 and 2009 was generally a good time to load up on shares of those same caliber of dividend companies, such as when Coca-Cola (KO) hit $40 per share or Colgate-Palmolive (CL) traded at only $55 per share. But the market isn't in a period of such extreme valuations (such as today) -- it's best to stick with the idea that some dividend stocks are overpriced, some are priced just about right, and some are bargains.
When it comes to dividend-based stocks, it's much easier to tell whether shares represent a bargain or not relative to their high-growth, non-dividend-paying peers. For instance, when you talk about a high-flyer like Amazon (AMZN), most of the company's price hinges on rapid growth in the future, which is more difficult to predict. As of right now, the company trades at $173 per share based on $1.90 in trailing twelve month earnings, for a P/E ratio of 91. Once you reach that nosebleed level of valuations, it's harder to identify what shares are really worth -- should Amazon trade at a multiple of 60, 80, 90, 100, 120? Will the company be able to grow earnings by 20% annually, or 30% annually? I'm not saying whether or not shares of Amazon are in a bubble, but I am saying this is the type of environment that lends itself to bubble-like behavior: an inordinately high reliance on what the company might do in the future, rather than what it's doing right now.
In the case of dividend-paying stocks, it's a bit easier to make determinations about the appropriate price one should be paying for an ownership stake in the business-there's a reason the daily chatter about the stock market does not clamor about Coke, Pepsi, and Procter & Gamble the way that companies like Apple (AAPL), Amazon, and Sirius (SIRI) get discussed.
Let's take the "King of Dividend Growth" over the past 50 years, Altria (MO), for example. The company currently trades at $29.79, for a P/E ratio of 17.80 relative to $1.67 in annual earnings and $1.64 in dividends (for a 5.51% dividend yield). Historically, investors have looked for 7-8% dividend yields from Altria (granted, this is a hard comparison to make, since Philip Morris International (PM) and Kraft (KFT) used to be part of the business), and the P/E ratio of 17.80 is way above historical norms for a tobacco company in the past twenty years (11-12x earnings has been the norm).
For instance, Colgate-Palmolive (CL) and Emerson Electric (EMR) are both companies with long histories of high-single-digit to low-double-digit earnings growth and annual dividend raises. Emerson currently trades at 14x earnings, and gives you a 3.43% dividend yield. In the case of Colgate, shares trade at 18.65x earnings and shares pay out a 2.49% dividend yield. Both are excellent businesses, but it seems that shares of Emerson have a larger degree of "margin of safety" built into the share price than Colgate.
The nature of dividend-focused investing is such that, for the most part, dividend-focused investors will not buy blue-chip companies paying out less than 2% annually in dividends or trade for 20x earnings or more. In fact, many of them have self-imposed rules that prevent them from buying dividend companies with present dividend yields less than 3% or trade at earnings multiples greater than 17 or 18. This type of self-imposed criteria does not really exist in the realm of the Apple and Amazon-type stocks. That's why I think it's not worthwhile to speak of dividend-focused stocks as being in a bubble -- they seem to defy that type of classification.
Because the country is in a low-interest-rate environment, income-hungry investors have bid up the shares of companies like Altria to higher levels that will probably deter them from making an initial purchase. On the other hand, companies like General Electric (GE) offer a 3.76% dividend yield and trade at 14.5x earnings -- at best, people will argue that shares of GE are cheap, and at worst, people will say the company is close to fairly valued. But very few people would argue that the present price of GE stock is currently in a bubble.
Because stringent investment standards are more applicable to dividend stocks than non-dividend, high-growth stocks, it's much easier to evaluate each company on an individual basis than to try to speak in terms of "dividend stocks are in a bubble." A much more honest statement would be this: The low-interest-rate environment in the United States has driven the price of some dividend companies way up, wiping out their margins of safety. However, some bargains remain. But I suppose that's not as catchy a headline.