Are Dividend Stocks Overvalued?

| About: SPDR Dividend (SDY)

Recently, there has been an ongoing discussion on Seeking Alpha regarding the merits of dividend investing. Questions have been posed about whether the companies generally belying this strategy have become overvalued due to the increasing positive support of this strategy, demographic factors favoring steady income streams, and the low nominal returns received from fixed income investments given declining interest rates. Thoughtful discussion (see articles I, II, III, IV, V) is the hallmark of Seeking Alpha, and I wanted to take a quick moment to opine on the relative valuation of domestic dividend stocks.

I wrote in May 2012 about "Dividend Aristocrat Investing," which invests in a portfolio of S&P 500 (SPY, IVV) constituents that have followed a policy of increasing dividends every year for at least 25 years. Since S&P began tracking this data in 1989, the Dividend Aristocrats - replicated approximately through the SPDR S&P Dividend ETF (SDY) - have outperformed the broader index by 2.2% per year while only exhibiting about eighty percent of the volatility. Below is a list of the current Dividend Aristocrats sorted ascending by price-to-trailing twelve month earnings and accompanied by their respective dividend yield:

Source: Bloomberg (market close 7/31)

While the constituents of the S&P 500 index that have met the Dividend Aristocrats requirements do trade at slightly higher earnings multiples (15.6x vs. 14.01x), nothing here signals a bubble. Flipping these P/E ratios into E/P ratios, or earnings yields, the Dividend Aristocrats' earnings yield of 6.41% is 73 basis points less that the earnings yield of the broader market of 7.14%. In this market environment, some participants would gladly trade 73 basis points of return for one-fifth less historical volatility.

Below is a graph of the price to trailing twelve months earnings ratio of the S&P 500 historically. The small dot at the far right of the graph is the P/E ratio of the Dividend Aristocrats today. At only 94% of the historical market earnings multiple, dividend stocks still appear relatively inexpensive in a broader historical context.
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Source: Bloomberg, Standard and Poor's

The nineteen companies that have yields in the "Dividend Sweet Spot" of between 3% and 6% have a capitalization-weighted earnings multiple of 15.79x. This earnings multiple values these Dividend Aristocrats roughly 13% higher for a dollar of earnings than the broader equity market.

The question for market participants is whether this higher valuation is justified. With economic outcomes remaining uncertain, asset allocations globally have shifted to less risky assets driving down the yields of relatively low-risk global sovereign bonds. Dividend Aristocrats almost by definition have stable business profiles and an economic moat in their respective industries to be able to return increasing amounts of cash to shareholders annually over long time intervals.

In my original article on the Dividend Aristocrats, I demonstrated that the returns of these securities have been decidedly less volatile than the broader market. This trend has held in 2012 with the Dividend Aristocrats producing a standard deviation of weekly returns of only 88% of the broader market. The total returns year-to-date of the S&P 500 and the Dividend Aristocrats have been roughly equivalent, but the latter had a less volatile ride as seen below.

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I believe an allocation to dividend paying stocks remains appropriate, and would certainly rather own a claim on the earnings and dividend streams of these companies than be a lender (owning the bonds) at similar yield levels, but with my upside capped in the bonds at return of principal. If global economic growth re-accelerates and corporate earnings surprise to the upside, the Dividend Aristocrats will underperform riskier sectors of the broader equity market as they did in the first quarter of 2012. However, I expect that the Dividend Aristocrats will continue to produce higher risk-adjusted returns than the broader market over long time periods, and I am willing to pay the premium to own these equities given the uncertain macroeconomic climate. Dissenting opinions can certainly take the other side of this proposition, which is the beauty of free markets. I look forward to following the debate on the merits of dividend investing on Seeking Alpha.

Links to the Dividend Aristocrats constituents:

3M (MMM), Aflac (AFL), AT&T (T), Abbott Labs (ABT), Air Products and Chemicals (APD), Archer Daniels Midland (ADM), Automatic Data Processing (ADP), CR Bard (BCR), Becton Dickinson (BDX), Bemis (BMS), Brown-Forman (BF.B), Chubb (CB), Cincinnati Financial (CINF), Cintas (CTAS), Clorox (CLX), Coca-Cola (KO), Colgate-Palmolive (CL),Consolidated Edison (ED), Dover (DOV), Ecolab (ECL), Emerson Electric (EMR), Exxon Mobil (XOM), Family Dollar Stores (FDO), Franklin Resources (BEN), Genuine Parts (GPC), W.W. Grainger (GWW), HCP (HCP), Hormel Foods (HRL), Illinois Tool Works (ITW), Johnson & Johnson (JNJ), Kimberly Clark (KMB), Leggett & Platt (LEG), Lowe;s (LOW), McCormick & Co (MKC), McDonald's (MCD), McGraw Hill (MHP), Medtronic (MDT), Nucor (NUE), PPG Industries (PPG), PepsiCo (PEP), Pitney Bowes (PBI), Proctor & Gamble (PG), Sherwin Williams (SHW), Sigma Aldrich (SIAL), Stanley Black and Decker (SWK), Sysco (SYY), T. Rowe Price (TROW), Target (TGT), VF Corp (VFC), Walmart (WMT), Walgreen (WAG).

Disclosure: I am long SPY, SDY.