Why a Popping Dividend Bubble Is Great News for Long-Term Investors

Last week, our award-winning columnist Morgan Housel penned a piece exploring the possibility of a dividend bubble. "Just as investors ran blindly into subprime bonds five years ago in search of yield, they're running blindly, carelessly into dividend stocks today," says Housel.

I don't disagree with him on that. In the aftermath of the recession and in such a low-interest-rate environment, dividend stocks have been all the rage.

But Housel's conclusion is this: "The more I look, the more it becomes apparent that stocks known for their dividends trade at unfortunate valuations that could leave investors disappointed." In the short to medium term, he's probably right. But if you're investing with a decades-long time horizon, I think this could be the best news you could hear.

Let me explain why.

The case of Altria
When Wharton professor of economics Jeremy Siegel went back and studied which companies produced the best returns from 1925 onward, he found something surprising. "I was frankly shocked that Philip Morris [now Altria (NYSE: MO  ) ] would be the number-one stock," Siegel said. "I would just never have guessed that. I would have said, 'Maybe IBM.'"

What Siegel found was two factors at play: The first was that investors often paid too much for growth stocks -- even ones that paid dividends. Although companies like IBM crushed competitors in revenue and earnings growth, their shareholders still underperformed Altria's. This was largely because shares of IBM were already priced for such growth.

This, I believe, is the crux of Housel's argument -- that paying for dividend stocks now will disappoint investors because they're paying far too much for them. I don't disagree with him -- dividend stocks are more expensive now than they have been in a while.

But the second factor that Siegel found at play was this: Depressed share prices allowed shareholders of Altria to accumulate more and more shares through dividend reinvestment programs, or DRIPs, than shareholders of other companies. In the case of Altria, the depressed share prices were largely due to fears of losses associated with lawsuits regarding the link between smoking and lung cancer.

It's in this second factor that I see reason for hope. If there's a dividend bubble that pops, but companies are easily able to continue paying the yields that they currently are, long-term shareholders (and I mean 10- to 20-year shareholders) will be accumulating more and more shares through DRIPs -- more cheaply -- than they would if prices remained the same as they are today.

Consider the hypothetical case of Philip Morris International (NYSE: PM  ) . In our first scenario, the company's share price and dividend payout -- which is about 3.8% today -- stays exactly the same for the next 20 years. In the second scenario, the absolute dividend payout by the company remains the same, but the share price dips 25% immediately after buying shares and stays there for the next 20 years, before coming up again to the same level they are today.

Here's what the results would look like.

  Total Return
Scenario One  110%
Scenario Two  167%
Difference  57 points

Source: Yahoo! Finance, author's calculations.

Of course, there are two important things to notice here. First, there's no way Philip Morris' stocks would follow such a neat pattern. And second, this assumes that the price of Philip Morris' stock would recover -- over the course of 20 years -- all that it might lose in the event of a dividend bubble popping.

But even discounting these assumptions, I think the hypothetical situation shows the power of holding dividend stocks when prices are depressed -- you simply accumulate more and more shares than you otherwise would.

Some stocks to consider
What Altria had going for it was simple: It was producing a highly addictive product with a powerful brand that had repeat customers. For this reason, both Altria and Philip Morris would represent good candidates moving forward.

But I've got some other choices for those wanting to stay away from cigarettes. Working with the same characteristics, I think the following three companies could offer excellent prospects for the 10- to 20-year investor.

Company

Dividend Yield

Coca-Cola (NYSE: KO  ) 2.8%
Proctor and Gamble (NYSE: PG  ) 3.3%
AT&T (NYSE: T  ) 5.9%

Source: Yahoo! Finance.

Coca-Cola and P&G both have some of the strongest brands in the world, as well as millions of repeat customers who will continue buying their products during good economic times and bad. I have little doubt that these two companies will continue paying out their dividends, as their payout ratios are both 60% or lower. All a drop in price would mean -- for the long-term investor -- is a chance to accumulate more shares through dividend reinvestments.

AT&T, on the other hand, has a much higher yield, which reflects a higher level of risk. The telecom industry is rapidly changing with the shift from landlines to cellular, and the possible encroachment of smartphone makers into the industry. Though the picture is a bit cloudier, I believe the company will still be around -- and paying dividends -- 20 years from now. With a yield like it has now, that's enough to convince me that it'd be a buy.

I'll be adding all three of these companies to my All-Star profile so you can track how they're doing. And if you're interested in learning about more rock-solid dividends, I suggest you check out our special free report on just that topic. Inside, you'll get the name of 11 dividend-paying companies our analysts think will outperform the market for years to come. Get your copy today, absolutely free!

Fool contributor Brian Stoffel owns shares of Coca-Cola. You can follow him on Twitter at @TMFStoffel.

The Motley Fool owns shares of International Business Machines, Altria Group, Philip Morris International, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Philip Morris International, Coca-Cola, and Procter & Gamble. 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 Motley Fool has a disclosure policy.


Read/Post Comments (14) | Recommend This Article (54)

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 February 13, 2012, at 4:10 PM, yoyom wrote:

    Don't forget, MO spun off PM and KRAFT to shareholders as well. For every 100 shares of MO shareholders received 100 shares of PM and about 70 shares of Kraft. All 3 decent dividend payers and prices that are more than encouraging. Now Kraft is getting ready to spin off a subsidiary to shareholders,.Anyone who bought MO 10 or 15 years ago and held is a lot richer now.

  • Report this Comment On February 13, 2012, at 6:02 PM, gascap77 wrote:

    The current version of AT&T was just created a few years ago when SBC (a Baby Bell) acquired what was left of the original AT&T and then changed its name from SBC to AT&T. Their monopoly franchise on iPhone wireless service is over. Where's the sustainable competitive advantage that the other four companies have?

  • Report this Comment On February 13, 2012, at 6:07 PM, Gorm wrote:

    While you might presume buyers are investors just shifting holdings, I expect many are conservative CD / Treasury buyers, ie seniors.

    This group felt forced to buy equities for dividend yield because their alternative choices were BAD:

    1) Buy into the bond bubble, potentially suffering huge losses on inflationary rate increases.

    2) Suffer with depressed income from CDs, Savings and Treasuries.

    3) Consume their principal - increasing the risk they'll outlive their assets.

    NOW, in that the Fed is suggesting ZERO rates thru 2014, dividends were a logical choice. BUT, what happens WHEN this market corrects. NO rational person expects the US to recover given our HUGE debt burden (Consumer debt), negative demographics, crisis in Europe, contracting global economies, etc.

    There is REAL downside and seniors are the ones to feel it most because their timeline is much shorter than you suggest!!

    Gorm

  • Report this Comment On February 13, 2012, at 6:35 PM, Mega wrote:

    "Just as investors ran blindly into subprime bonds five years ago in search of yield, they're running blindly, carelessly into dividend stocks today," says Housel.

    Actually, the problem was not subprime bonds. The problem was investment grade bonds, manufactured out of subprime assets.

  • Report this Comment On February 13, 2012, at 11:38 PM, TMFCheesehead wrote:

    @MegaShort-

    One and the same. Subprime bonds were investment grade bonds. That was the whole problem. Thank S&P and Moody's for that mess.

    @Gorm-

    Three things:

    First, you're right. For seniors who are counting on that money within a much shorter time frame, the story is different, which is why I made it clear that this was for those with a 10 to 20 year time frame.

    Second, I don't think the example I lay out even applies if seniors are investing dividend stocks, as it seems you're assuming the seniors will be using those dividends for income, rather that for DRIPs.

    Third, if anything, a lowered interest rate environment or a faltering economy would HELP seniors holding onto solid dividend companies, as there would be a secondary "flight to safety". It's the economy improving, and interest rates rising as a result, that could really hurt short-term dividend holders.

    Brian Stoffel

  • Report this Comment On February 14, 2012, at 1:16 AM, sfdint wrote:

    Isn't a "dividend bubble" a bit of rhetorical overkill? When I look at the big names that are the bulwark of dividend investing I don't see any eye popping P/E ratios or anything that would indicate there is a "bubble" to "burst". Certainly nothing remotely comparable to the sub-prime housing mess. Maybe a dividend stock "correction"?

  • Report this Comment On February 14, 2012, at 4:41 PM, Joemit wrote:

    The only :"bubble" may be in some of the REITs that pay double didgit dividends now and some which have been paying them for a few years.

    Sysco(SYY) , PG, T, JNJ, KO, PEP and even MO are generally characterized by having a competitive advanges with a product placement(s) that have no serious compeitor that will cause their business to fail completely as Eastman Kodak seems to have done or Underwood.

    There will still need to be an ATT or Verizon (VZ) to provide the service for the cell phone to exist.

  • Report this Comment On February 15, 2012, at 12:00 PM, bronzeguy wrote:

    well, too bad the Fool is so interested in a company that sells a verifiably cancer-producing product. Oh no! not that pesky issue again.

  • Report this Comment On February 17, 2012, at 12:42 PM, WineHouse wrote:

    Brian Stoffel -- your mindset seems to be set in the world of capital gains, so you fail to appreciate the appeal of high-quality dividends to seniors who are dependent on the dividends for income to meet expenses. To help you understand why even seniors are better off with dividend-growing stocks during inflationary times, let's imagine the following:

    You hold 1,000 shares of General Mills (GIS), paying you a tad more than $3,000 per year in dividends as of right now. In a couple of years, inflation hits and impacts us exactly the same way it impacted us during the Nixon and Reagan years -- 30 year fixed mortgage rates in the 11-16% range, long-term CD's paying 8-12% interest, prices of raw materials and finished goods and services increasing 5-10% per year. Now: what's going to happen to the SHARE PRICE of GIS? It will go DOWN, of course. That would be bad news for "capital gains" investors. But what do you think will happen to the dividend payout? Yes, GIS will have to pay more for the oats and the cardboard boxes; but it will also be able to pass on those increased costs to the consumer due to price increases, thus maintaining its profit margins. And the kinds of products that GIS produces (necessities) will continue to be purchased at close to the same volumes, unlike more luxurious items that can be deferred until times are better. The dividend payout would either continue at current levels or, more likely in fact, it would continue to increase slightly year over year. Now tell me, who's better off -- the "capital gains" investing seniors who've taken a big price-based bath, the fixed-income-investing seniors who are stuck with lower rates of fixed income despite rising costs, or the high-quality-dividend-growth investors, who are no worse off than the CD investors and possibly better off?

  • Report this Comment On February 19, 2012, at 2:34 AM, DBGPugh wrote:

    The previously mentioned comment about PM and MO causing cancer is a complete non-issue. People foolishly claim that they are against supporting a tobacco company and, therefore, will not buy shares in a tobacco company. What they do not realize is that the money they are investing goes only to the previous holder of the shares, not the tobacco company. Only if you bought the initial public offering would you be giving money to the the tobacco company. And guess what? The fully-legal tobacco company is going to exist and all of its shares will be purchased and traded whether you are benefiting from the profitability of the company or not. If your concern is being moral when it comes to stock market investing, bear in mind that you are only giving your money to the previous stockholder (not an "ethical" company) and donate your gains to charity.

  • Report this Comment On February 19, 2012, at 2:47 AM, DBGPugh wrote:

    Why be morally judgemental against the the tobacco stocks and not the stocks of the many companies such as Pepsi (and many other similar companies) that make junk food that causes the exact some problems as tobacco does such as heart attack, stroke, cancer, etc. in addition to obesity, joint problems, and diabetes.

    By they way, I did not hear of anyone not buying Kraft food products in the past out of a desire not to send money directly to PM.

  • Report this Comment On February 19, 2012, at 9:46 AM, gilsh wrote:

    I just don't get it:

    1) "If there's a dividend bubble that pops, but companies are easily able to continue paying the yields that they currently are... "

    But why would they ? you pay high yields if you have to attract investors. If a bubble bursts, the competition is much lower. The better the company, the lesser need it has to attract investors by its dividends. Hence, the best companies will not raise their dividends forever, and they may very well lower them at times.

    2) since when has it become wise to buy stocks that are expensive ?

  • Report this Comment On February 19, 2012, at 9:57 AM, TMFCheesehead wrote:

    @WineHouse-

    As I said in my piece, my piece is meant to focus on investors with a 10-20 year time horizon who set up DRIP accounts.

    @glish-

    I wouldn't necessarily say that companies offer dividends just to attract investors. Companies have to do something with their cash on hand, and dividends are a great use for the mature company.

    A bursting bubble refers just to stock prices, not to the underlying business--which are very stable.

    Finally, buying "expensive" isn't the point of the piece, rather, it's that for those already holding shares of quality companies for the long-run--there's actually a benefit to prices collapsing (so long as they recover by the time the stock is sold).

    Brian Stoffel

  • Report this Comment On February 21, 2012, at 10:05 PM, UFOFred wrote:

    @ DBGPugh

    >>> By they way, I did not hear of anyone not buying Kraft food products in the past out of a desire not to send money directly to PM. <<<

    I am one such consumer -- I've avoided buying Kraft, Maxwell House, Post, Nabisco, etc. because of their tobacco connection. Fortunately, there are alternatives.

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