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The Dividend Bubble Could Last for Years

Now more than ever, investors look first for stocks that will pay them healthy dividend income. As a sign of stability and security, a decent dividend yield has become the first hurdle that many investors apply in their screening process for good investments.

As happens with any popular investing trend, some skeptics have worried that the popularity of dividend stocks has inflated their valuations above what's fair. Yet from a fundamental standpoint, the underpinnings of dividend stock prices appear to be strong, and they could keep getting even stronger for years to come.

Rising payouts support stock prices
The primary way to assess whether a dividend stock is fulfilling its purposes in your portfolio is to look at the income it generates. Just about the worst thing that a stock known for its dividend can do is to cut its payout, as it invalidates the investing thesis of many of its shareholders. That's the challenge that recent dividend cutters Chimera Investment (NYSE: CIM  ) and Frontier Communications (Nasdaq: FTR  ) face, as the double-whammy of big drops in share prices and significant drops in dividend income have pushed many investors to greener pastures after suffering big losses.

But, when you look at the overall market, dividend payouts broadly have never been better. As Barron's reported yesterday, S&P Dow Jones analyst Howard Silverblatt discovered that August's dividend payout of $34 billion from S&P 500 stocks will exceed the previous record level of $32.1 billion from last November. A big part of that comes from Apple (Nasdaq: AAPL  ) , whose $2.65 per share quarterly dividend payout earlier this month amounts to about $2.5 billion in total payments to shareholders.

Even more importantly, Silverblatt notes that even without any changes at all, continuing dividend payouts at current levels would produce a rise of nearly 6% in aggregate dividend payouts in 2013. That should make dividend investors feel pretty confident about future prospects.

A market of stocks
As reassuring as it may sound to hear that dividends for the market as a whole look healthy, it doesn't excuse failing to look more closely at your portfolio to look for danger signs among the individual dividend stocks you own. Just because the overall market is well-off doesn't mean that you won't find problems with particular stocks.

Just a quick look at valuations across sectors can give you clues as to where warning signs may be flashing. Looking at data on forward earnings multiples from Factset Research, the telecom sector carries the priciest valuation, averaging 18 times next year's estimates. That's fully 40% higher than the multiple for the S&P 500 as a whole. Utilities, which are also well-known for high dividend payouts, are priced at 15 times forward earnings, well above their 10-year average multiple.

By contrast, areas where dividends have typically been less prevalent are relatively underpriced. Technology stocks are perhaps the biggest outlier, with a multiple below the market's average and nearly a third less than normal levels based on historical data. Yet even in the tech sector, you're seeing increasing dividend payouts, including a host of companies initiating new dividends. In fact, thanks in part to a big new dividend from Dell (Nasdaq: DELL  ) and a huge increase from Cisco Systems (Nasdaq: CSCO  ) , tech stocks now pay more in dividends than any other sector of the S&P.

The disparities across sectors suggest that one way to protect yourself would be to look more closely at the valuations of each stock you own and see whether they represent fair value. In some cases, you'll find that multiples aren't justified by growth expectations for earnings and dividend payouts. By concentrating instead on stocks that have a margin of safety in their valuations, you'll be better prepared for the most likely scenario: a selective bursting of the dividend bubble that focuses on overvalued individual securities.

Be smart
Dividends are so popular as to resemble a fad, but that doesn't make all dividend stocks bad investments. It just means you have to be more careful to make sure you don't make avoidable mistakes. For the right stocks, the popularity of dividends could go on for years to come.

Even with its dividend cut, Frontier Communications remains a high-yielding play. But can the dividend last? Find out everything you need to know in the Fool's premium report on Frontier Communications today.

Fool contributor Dan Caplinger likes his dividends but is careful about them. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Cisco Systems and Apple. Motley Fool newsletter services have recommended buying shares of and creating a bull call spread position on Apple. 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. The Fool's disclosure policy never stops paying dividends.

Read/Post Comments (3) | Recommend This Article (21)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 31, 2012, at 4:00 AM, susan400 wrote:

    TMF you have it wrong heren, you are seeing from monovision. There are buyers and sellers.

    When a co cuts its dividend, it just isn't paying out what is your money anyway.

    If a lower payiout helps the co in a tough period, it generally gets restored. SEE 1980s, if you bought utility stks everytine they cut the div, you outpreformed the snp by 1200 basis points.

    "have pushed many investors to greener pastures after suffering big losses." actually the GREENer is the buyer of the stks sold because the DIV was cut.

    Each to his own but research facts vs making assumptions, is my suggestion.


  • Report this Comment On August 31, 2012, at 9:30 AM, FoolishLonghorn wrote:

    Q: Why are dividend stocks popular right now?

    A: Because interest rates are low. Investors are seeking yield.

    Q: Why are interest rates low?

    A: Because the economy is not doing well.

    When (if?) the economy substantially improves, interest rates will rise, When a CD pays more than the dividend yield on your average S&P 500 stock, some money will move to fixed income investments, and some will move to growth stocks.

    There will always be a market for big dividend companies--better return than fixed income, and less risk that smaller growth companies.

    But there is no evidence that there has been a fundamental change in investor mindset that would indicate the current popularity of dividend paying stocks is will be permanent.

  • Report this Comment On August 31, 2012, at 5:41 PM, donbcms wrote:

    NO interest anywhere else?? (example:HCBK?

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