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This is the second part of my review of recent research on dividend stock investing. The first installment highlighted reasons for following a dividend stock investment strategy and provided supporting historical data. Advantages included serving as an inflation hedge, providing a growing income stream without the need to sell shares, and superior long-term total returns with lower volatility. It concluded with some sub-groups of dividend growth stocks that have outperformed historically. I greatly appreciated the positive responses and the quality of the comment thread. I hope this article will be equally informative and engaging. In addition to using reports from BlackRock, Columbia Management, and Eagle Asset Management, this article includes data from additional publications by Westwood and Commonwealth Bank & Trust Company. Links to all of these reports are at the end of the article.

With increased market volatility in recent years and interest rates at historic lows, dividend stocks have become quite popular. Just this week, while talking with my mom, she mentioned that CD rates were a pathetic 1%, and we discussed some potential dividend growth stocks to purchase instead to get a better income stream. With millions of other retirees probably thinking like her, it is no surprise that dividend stocks have gotten a bit pricey lately. Does this mean that dividend stocks are no longer a good investment? Let's take a look at some demographic and financial data and decide!

Investor Behavior and Demographics

Columbia's report noted that after suffering losses in 2008-2009, many investors are seeking to reduce portfolio volatility and preserve capital. In addition, behavioral finance studies have shown that investors give more weight to recent experiences and tend to over-generalize this into the future. Investors also experience greater emotions from losses than gains, leading to loss avoidance strategies. Collectively, this leads to an increase in the number of cautious investors looking for less volatile, income-producing investments. Dividend growth stocks are a natural fit for this group, as they have historically had lower volatility, growing income streams, and include many big-name firms that provide a sense of comfort and security. Who wouldn't sleep well at night owning Procter & Gamble (NYSE:PG) or Kimberly Clark (NYSE:KMB)?

Population demographics also result in more dividend stock investors. The U.S. and world populations are aging. The United Nations estimates the global retirement-aged population will triple to 2 billion by 2050. In the U.S., the baby boomer generation is entering retirement; Eagle Asset Management [EAM] reports that 80 million Americans will retire in the next 20 years. This is a lot of people who will desire growing income streams to support them in retirement, while simultaneously protecting their capital. In addition to the number of retirees, two other trends will increase the demand for income. Today's retirees have a longer life expectancy and high standard of living expectations. Low-yielding government bonds and bank CDs aren't going to meet their needs.

Dividend growth stocks offer an attractive alternative, though with more investors, long-term returns may be lower than historic averages, as stock valuations will be higher and yields lower. Being patient and waiting for entry points can help to mitigate this concern, though with the increased demand for dividend stocks, it may take bad news to really bring prices down to the value level. Over the longer-term, assuming earnings and dividends keep growing, I'm less concerned about the slight overvaluation of DG stocks. Research suggests that DG stocks should still deliver decent returns and better returns than bonds.

Interest Rates

(click to enlarge)Yields vs 10-yr

Commonwealth Bank & Trust Company [CBTC] believes that high quality dividend stocks are priced to deliver mid-to-high single digit returns, with lower volatility over the next 10 years. While below the historic stock market average of around 10%, relative to the 10-year Treasury rate of 1.72%, that seems pretty attractive. Given the low interest rate environment, we should not expect the historical return rate from the stock market. The increased demand for dividend stocks will raise valuations, making it harder to buy in at an undervalued price. However, compared to the alternatives, dividend growth stocks should still be a good investment, particularly for those focused on income. Someone who bought Johnson & Johnson (NYSE:JNJ) in October 1999 at $105/share (pre-split) still made a 4.5% compound annual return over the last 13 years. Not stellar for total return investors, but still better than current bond yields. Also, this was at the height of the Internet bubble, and we aren't near that level of overvaluation.

As observed in the chart above, an increasing number of stocks now have yields higher than the 10-year Treasury and with low payout ratios, which allows for continued dividend increases. My High-Yield, Low-Payout model portfolio targets this sub-group and includes well-known companies such as AstraZeneca (NYSE:AZN), Hasbro (NASDAQ:HAS), and Microsoft (NASDAQ:MSFT).

(click to enlarge)Payers vs non-payers

But what about when interest rates eventually go up? Conventional wisdom says that dividend stocks will decline, but so will non-dividend stocks. Interest rates would probably need to go up quite a bit from the current level before the 10-year Treasury becomes true competition for higher-yielding dividend growth stocks (3.5%+). Furthermore, Westwood cited the Ned Davis Research in the above chart that shows dividend growers historically perform well when inflation and interest rates rise, exceeding the returns of non-payers in all three interest rate scenarios. Focusing on dividend growth stocks also provides growing income, which bonds cannot match.

What About the Potential Dividend Tax Rate Increase?

As the "fiscal cliff" approaches, talk of higher dividend tax rates negatively impacting dividend stocks has increased. Supposedly, companies may scale back on dividend payouts because investors will get taxed more, and dividend stocks will become less attractive to investors. While the shock value of such headlines may be high, the bite may be a bit smaller. So far, dividend investors appear undeterred by the fiscal cliff scenario, and based on the research, perhaps rightfully so.

Westwood's research found little correlation between the dividend tax rate and corporate payout ratios. Prior to 2002, dividends were fully taxed at the investor's personal income rate (Note: from 1954-1984, there was a small $50-$100 exemption), yet dividend payouts ranged from 42% to 64%. Since 2002, when the Bush tax cuts lowered the dividend tax rate, corporate payout ratios have fallen.

Columbia's analysis on the effect of a tax rate increase on investors' income suggests that the impact may be smaller than expected. First, there is the potential for new legislation to stop the rate hike. Mitt Romney wants to keep the Bush tax cuts and President Obama's deficit reduction plan would only raise dividend taxes to 20% for those making over $200K (single) or $250K (married). Both of these scenarios are a far cry from the top income tax rate of 39.6%. Using 2007 IRS data, Columbia found that $244B (65%) of all dividends went to individuals making over $200K, but only $101B (~40%) of this amount was qualified dividends. So in effect, only 26% of all dividends paid to high-income individuals received favorable tax treatment; the rest was already being taxed at personal rates. Perhaps the more telling statistic is that only 3.2% of individual tax returns had income levels over $200K. Further, dividends paid to IRAs are unaffected. Regardless of the tax impact, where else will we put our money to get 3.5%+ yields and growing income streams?

(click to enlarge)Performance around tax increases

Lastly, CBTC cited a Morgan Stanley report showing that dividend-paying stocks historically outperformed non-paying stocks significantly more when dividend tax rates were 32% to 50%. If no legislative changes occur, the top end dividend tax rates will fall within this range. The research also showed that while dividend stocks did not underperform in the months prior to a tax rate hike, they did underperform in the first six months after the hike, but then resumed positive relative performance.

Summary

So does this mean dividend stocks are no longer a good investment? I think it depends on where we set our expectations. Through a combination of demographic trends, investor behavior, and low interest rates, the demand for dividend stocks is increasing. With more people and money searching for an alternative to low-rate bonds, dividend stock valuations are rising and yields decreasing. We are already seeing signs of this today with PG and KMB trading at P/E ratios over 18, and yields below 3.5%. Dividend stocks seem to be slightly overvalued, though with the increased investor demand for yield and dividend stocks, and interest rates at historical lows for the next few years, perhaps this is the "new normal," at least for the next few years.

Income-oriented investors should be fine over the longer-term, and can include MLPs, mREITs, or BDCs to raise their portfolio yield. Total return investors may want to be more selective and wait for better entry points on their target stocks, though research believes DG stocks will still provide 6%-9% total returns over the long-run. Relative to Treasuries, that looks attractive especially with companies in a position to continue growing their dividends; something bonds don't offer. The tax concerns appear minor, as there is a fair chance the middle class will be spared, IRAs and non-qualified dividends are unaffected, and dividend stocks will still have higher post-tax returns than bonds and CDs.

If many investors do choose to bail out on dividend stocks due to taxes or higher interest rates, yields will increase from the price decline, and with more investors looking for income, I believe DG stocks will find support. A key will be continued dividend growth. The final installment of this series will focus on the corporate financial data that shows a lot of room for firms to increase their dividends.

Sources:

BlackRock Investment Institute (March 2012). Means, Ends, and Dividends: Dividend Investing in a New World of Lower Yields and Longer Lives.

Eagle Asset Management (June 2012). Dividends Deliver: Dividend-oriented investments can offer much more than income.

Columbia Management (April 2012). The Tip of the Iceberg for Dividend Stocks.

Westwood (April 2012). Dividend Paying Stocks: Fact vs. Fiction.

Commonwealth Bank & Trust Company (June 2012). Monthly Investment Commentary: Reviewing the Risk and Reward of Investing in Dividend Paying Stocks.

Source: Dividend Stocks Remain Relatively Attractive Despite Concerns Over Valuation And Taxes