Over the past few years, investors have been enamored with higher-paying dividend stocks. Simultaneously, there has been a pronounced bias toward defensive, lower-volatility sectors and industries. Combining the two trends, the more defensive, higher-yielding niches of the market (pharmaceuticals, consumer staples, telecommunications and utilities) have had very powerful gains since 2011, continuing into 2013.
As the S&P 500 has reached all-time higher ground, led by more defensive sectors in general, the question is whether the focus on dividends, particularly defensive dividends, will continue to provide market leadership.
Let's examine why the dividend play has become so sought-after. We believe its attractiveness is not so much a fundamental equity selection as it is a fixed-income and perceived lower-volatility alternative selection.
Simply stated, we view a good deal of the demand for higher-dividend-paying stocks as coming from fixed-income investors who have been frustrated by rock-bottom bond yields, which have been produced in part by the Fed's stimulative quantitative easing policy and practices.
These investors are increasingly seeking the higher returns and favorable tax treatment offered by dividends. Fixed-income buyers who want stability have gravitated toward companies that offer lower volatility and greater predictability of maintaining and possibly increasing their dividend payouts.
We also believe these stocks' recent successes, combined with their attractive yields, have spurred equity- and momentum-oriented investors to jump on the bandwagon.
We believe the demand for dividend stocks will continue as long as the Fed maintains the status quo of low interest rates. This will likely propel such stocks higher, particularly if these companies meet earnings expectations and increase their dividend payouts.
There is, however, one important caveat: valuation. While we too are attracted to dividend-paying stocks, as value investors we have some real qualms about the prospects of the richly valued defensive sectors -- such as consumer staples and utilities -- which have been standouts for the overall market and have provided performance leadership among the dividend payers.
These leading sectors are now trading at price-to-earnings multiples at the high end of their historic ranges and at the very high end of the current spectrum of P/Es in the market. Yes, we are comforted by the stability of these current market leaders. But we nevertheless worry about possible contractions of earnings multiples, and therefore price declines, if the market believes the prospects of individual companies have diminished or that the dividend strategy's overall appeal has declined.
However, there are equally attractive dividends to be found among some of the more attractively valued, economically sensitive names in such sectors as energy, financials, industrials and technology. While fixed-income-oriented investors might be a bit more apprehensive about the higher cyclicality and business volatility of these companies, the irony is that this may be a less vulnerable way to approach dividends. These companies' attractive P/E levels should provide some downside protection and continued upside opportunity.
While momentum can carry the defensive high-yielders higher, at some point valuation will matter; it is therefore important for investors not to get carried away with the optimism of the group. The more extended the valuations are, the more important it becomes to be selective.
For new monies, we recommend focusing on higher-dividend stocks and sectors that have not led the rally of the past few years. We are very comfortable in building new positions in energy, financials, industrials and technology. Some strong dividend-paying stocks that should participate in this next leg higher are Cisco Systems (CSCO), ConocoPhillips (COP), DuPont (DD), Emerson Electric (EMR), General Electric (GE), JPMorgan (JPM), Royal Dutch Shell (RDS.B) and Wells Fargo (WFC). All offer dividends above 3% yet sell at reasonable valuations and have strong and growing businesses.
Bottom line: The dividend play will stay viable at least as long as the Fed continues in low-interest-rate mode. However, investors should be increasingly selective as to which dividend payers they gravitate to.