Is There Really a Dividend Bubble?

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If investing mirrors fashion in any way, maybe it's not surprising that vests and pageboy hats are back in style at the same time that dividend investing is making a serious comeback.

Unlike the high-octane, algorithm-driven trading that has cropped up on Wall Street in recent years, dividend investing has a long, rich history. In fact, we could probably say that it's investing at its purest and most basic form -- an investor buys a stake in a company, and in exchange that company shares part of its profits with said investor.

This classic style of investing all but disappeared for a long time as investors toasted to high-flying Internet and biotech stocks. But after being sufficiently sobered up by not one, but two major stock market crashes since the beginning of the millennium, dividend investing is back. And it's back big, baby.

But has it gone too far?
I recently wrote an article looking at how higher-yielding dividend stocks perform versus their lower-and-no dividend counterparts through various market conditions. Though my conclusion was, "Add that all up and we once again confirm why dividend stocks are the choice for investors looking for reliable, consistent returns," the mere suggestion in the article that dividend stocks aren't the cure for everything from a sickly portfolio to male pattern baldness and high blood pressure elicited some... let's say "strong" responses.

"Hmm," I thought, "when investors get this fired up about any segment of the market, it usually doesn't end well."

To be sure, I've been scratching my head over the outcome of the rise of the dividend for some time now. And more recently, my fellow Fool Morgan Housel went so far as to use the dreaded "b" word (that's right, "bubble").

But while there's a lot of chatter about dividend stocks, that may or may not mean much of anything. So I thought I'd take a closer look at what the numbers have to say.

And how about those numbers?
The quick, easy retort to claims of a dividend bubble is to say that such a bubble would be self-deflating because when investors start crowding into a dividend stock, the price rises, which causes the dividend yield to fall and, in turn, cools investor interest.

But that's not necessarily true, because if you have a company that's steadily raising its payout ratio -- that is the proportion of earnings that it pays out as dividends -- then investors could be pushing up the price of the stock and may not see a corresponding dip in the yield.

In other words, judging a dividend stock on yield alone is a bad idea.

Taking that into account, it makes sense to take a broader view when trying to figure out if there's actually a dividend bubble. In this case, I decided to look at three factors: dividend yield, valuation, and payout ratio.

Since you're likely dizzy with anticipation for the result, let's cut right to the chase. Looking broadly, there is no dividend bubble. Or if there is one, it's got a lot of inflating left to do before it'll be worrisome.

To get to that conclusion, I looked at 10 years' worth of data for all S&P 500 stocks that currently yield 2% or more. On the basis of both average and median, the current yield for those stocks is higher than the historical yield, current valuation is lower than the historical valuation, and payout ratio is lower than the historical payout ratio.

There's always a "but"
This doesn't mean that you can throw caution to the wind and go out and buy anything with a payout. In his article, Morgan highlighted Consolidated Edison (NYS: ED) and Altria (NYS: MO) in particular as dividend payers that look bubblicious. And it's hard to argue with him there. Altria's dividend yield is roughly in line with its 10-year average, but it sports a higher valuation and a higher payout ratio than it's had in the past. Meanwhile, Consolidated Ed's payout ratio has remained pretty stable, but its yield is notably lower than its 10-year average while its valuation is above average.

And they're not alone. Many stocks in traditional dividend havens like utilities and REITs raise some red flags in terms of whether investors should be jumping in now. Health Care REIT (NYS: HCN) and Progress Energy, for instance, are both "triple threat" dividend stocks in that current yields are lower than their historical yields, while valuation and payout ratio are both above past levels.

But again, as the overall averages I mentioned above suggest, there are plenty of solid dividend stocks that don't look like they've been pushed to worrisome levels. Waste Management (NYS: WM) has seen its payout ratio rise over the years, but its current yield is well above its historical level, while the stock's valuation is comfortably below the average level. The same could be said for food-distribution giant Sysco (NYS: SYY) .

Unexpected findings
When I set about pulling together this data, I didn't expect to find such a compelling case against a dividend-stock bubble. But that's exactly why it makes sense to do an exercise like this -- sometimes what seems to make sense or feels logical isn't backed up by reality.

That said, as Consolidated Ed, Health Care REIT, and some of the other stocks I noted above show, it's not a homogenous pool that dividend investors are fishing in. There are still good opportunities to be had, but grabbing anything with a yield may not work out the way you'd like.

And speaking of good opportunities, The Motley Fool commissioned a special report to identify some of the top dividend stocks available. You can download a free copy of that report by clicking here.

At the time this article was published The Motley Fool owns shares of Waste Management and Altria Group. Motley Fool newsletter services have recommended buying shares of Waste Management, Sysco, and Health Care REIT. Motley Fool newsletter services have also recommended creating a write covered strangle position in Waste Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.Fool contributor Matt Koppenheffer owns shares of Waste Management and Sysco, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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