Are Dividend Stocks Getting Too Hot?

Includes: COP, INTC, JNJ, MO, PFE, PM
by: Bio Insights

Historic data shows that dividend-growth investing is one of the (if not the) best strategies for generating investment returns in more developed stock markets. This has certainly been an easy argument to make with larger US dividend stocks lately, since many been growing their yields much faster than inflation.

Some companies have done particularly well - especially Intel (NYSE:INTC), which has increased dividends by 30% in the last two years. The dividend favorite of the energy sector, ConocoPhillips (NYSE:COP), grew dividends by 17% in the last two years. Pharmaceutical giant Pfizer (NYSE: PFE) hiked its payouts by 18% since 2010.

With inflation hovering around 2%, and US treasury yields far lower (the 10-year t-bill yield is 1.74%) it's obvious that equities were/are the place to be. I've made this argument many times before, since it seemed wise for investors to put their capital towards the securities that could at least pull their own weight against inflation.

Having said that, it seems that dividend stocks are getting more popular than ever. I tend to grow concerned when I see front-page articles on the Wall Street Journal like this one. In case you haven't seen it, the gist of the article is simple - dividend stock payouts have justified the rally of certain popular dividend stocks, and many asset managers can't get enough of the passive return.

Among the recommendations was Johnson & Johnson (NYSE: JNJ), which grew its dividends by 12% since 2010. JNJ is mentioned very frequently in the world of dividend investors, and has become expensive as a result. Since it generates so much attention, it seems that the market will not let it rise or fall out of its trading range. This is only reinforced by the snail-like movement of their financial data, which suggests no direction for the stock any time soon.

I've written about the stock in the past, and basically call it "a bond with a 3.5% yield". Since the stock moved up by only $3 since I started saying that, it's proven to be a relatively accurate statement. JNJ is an overheated stock, but doesn't seem to let itself cool off due to popularity. If you like it, it's a good core holding, but it's probably better to juice your returns. Use the strategy described here, which advises the selling of call options when JNJ approaches its upper trading range.

What about the other dividend stocks? Are they getting less attractive, given all the attention that is being placed on them?

Yes, because they're getting expensive. One good example is Pfizer, which I really liked in March at $21.50/share. The yield was 4.1% at that point, and the stock was 16% cheaper. The tobacco giants Philip Morris (NYSE: PM) and Altria Group (NYSE: MO) are also a bit expensive, with respective yields of 3.6% and 5.2% that were higher before an inflow of buyers started driving share prices up.

The stock market is also sitting at 5-year highs, which should add another layer of apprehension for stockholders. On the bright side, there are two major factors that should keep dividend stocks (in particular) expensive for quite some time.

First, there are the consistent dividend hikes that we talked about before. So long as companies can continuously improve operating profit margins, there's room for more dividend growth with virtually no top-line growth. Intel, for instance, can impress dividend/value investors and drive up their stock without ever growing sales - the company simply needs to find a way to reduce its expenses and dispense more cash to INTC holders.

Secondly, I see plenty of capital that is still trapped in the low-yield bond market. Bonds, especially treasury bills, are not offering much to the buyers who are looking to enter this late into their bull-cycle. People who can tolerate risk will opt for dividend stocks, which offer a better yield that is likely to grow in time.

So, while dividend stocks were obvious buys earlier in the year (when I was highly recommending them), the market's sentiment has shifted quite a bit. Yields are lower, and the outlook on the US economy hasn't shifted much. Also consider that we're getting closer to the hike in dividend tax rates (from 15% to 43%).

You probably shouldn't dump your dividend stocks outright, but to me it seems like a pretty good time to sell some covered calls on some positions to squeeze extra money out of the overbought and relatively expensive market. This allows you to cheer in the event that we see sideways or bearish trading in the next few months, which gets more likely with every uptick.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.