Dividend Bubble? That's Unpossible!

The notion that there's a "dividend bubble" has been particularly hard to kill. But let it be known: There is no dividend bubble, and it's essentially impossible for one to inflate.

Yes, that's bold.

However, I feel confident saying that because of the way we tend to think about dividends. When we discuss dividends, we're almost always talking about a stock's dividend yield, as in, "Caterpillar (NYSE: CAT  ) has a 2.3% dividend yield."

The way dividend yield is calculated is by dividing the total amount of dividends the company pays annually ($2.08 in Cat's case) by the current stock price ($86.91 for Cat as of this writing). So if investors start going after dividends like a pack of rabid raccoons on a stinky garbage can, the stock price rises and brings down the dividend yield. In other words, the higher Caterpillar's stock goes, the less attractive it becomes from a dividend-yield perspective.

Might the rush for dividends push some stocks' valuations up a little higher than they should be? Sure, that's possible. But it's extremely unlikely that we'd see a bubble that's anything like the dot-com stocks at the turn of the millennium.

The current focus on dividends may feel like a bubble because dividends have gotten so little love in the past couple of decades. However, the mistake was the previous lack of enthusiasm for dividends -- not the current shift back toward dividend-paying stocks.

What to watch out for
This doesn't mean that investors' refocusing on dividends doesn't come with some risks. The most notable risk is the potential for investors to chase certain stocks simply because they have high dividend yields.

I'm a big believer in dividends and think they can say good things about a company. Notably:

  • That management recognizes that shareholders own the company and are entitled to share in the profits.
  • That management isn't holding onto lots of shareholder capital that it may waste in the future on ill-advised acquisitions or badly timed share buybacks.
  • That the company is established and profitable enough that it can afford to pay out some of its cash.

However, a dividend isn't a guarantee that any of the above are true, and it certainly isn't an automatic green light that a company is a worthwhile investment.

Dividend or not, investors still have to do their homework -- that is, understand the business they're investing in and what that business is worth. There are signs that some dividend-hungry investors aren't doing this. A great example is Great Northern Iron Ore (NYSE: GNI  ) .

Great Northern is a land trust that's set to end in 2015. The company sports a huge dividend yield, but when I ran through some simple calculations at the beginning of 2011 it seemed highly unlikely that investors were going to recoup their investment -- let alone earn a profit -- before Great Northern's trust ended.

While Great Northern was an egregious example of investors tripping over themselves in pursuit of dividends, there are plenty of other places where investors can get themselves into trouble. For example, there are other high-yielding trusts, e.g., BP Prudhoe Bay Royalty Trust (NYSE: BPT  ) and its 9.9% yield, as well as a group of mortgage REITs, including Annaly Capital (NYSE: NLY  ) and Chimera Investment (NYSE: CIM  ) , that have been particularly popular with investors.

It's essential that investors understand the underlying businesses for all of these companies. After all, it's profit that funds the dividends. A lack of insight into the business would leave shareholders clueless about any developments that could hurt that all-important payout.

For the last time...
So, no -- there is no dividend bubble. However, as investors start to think about dividends again, there are opportunities for them to invest in bad companies or companies that they don't understand. Both are a big problem, but both have a lot more to do with laziness than anything else.

If you've zeroed in on Annaly Capital because of its huge yield and want to learn more before you buy, you'd better check out the special report from Fool analyst Ilan Moscovitz. Ilan breaks down the situation at Annaly, including "the three areas that you MUST watch." Click here to find out more about this report.

The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer does not have a financial interest in any of the 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.


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  • Report this Comment On September 27, 2012, at 2:39 PM, ryanalexanderson wrote:

    > So if investors start going after dividends like a pack of rabid raccoons on a stinky garbage can, the stock price rises and brings down the dividend yield.

    By that logic, Matt, do you also believe that it's impossible to have a bond bubble? And wouldn't you call a negative real yield in US Treasuries (and even worse, a negative nominal yield in parts of Europe) a bubble?

    Not trying to catch you out with this question; I honestly want to know what you think.

  • Report this Comment On September 27, 2012, at 5:40 PM, TMFKopp wrote:

    @ryanalexanderson

    Great question! I hope you won't accuse me of playing semantics here, but here's how I think about it...

    With bonds currently, what is it that people are buying? Yield? Hardly, if they wanted that, they'd go after Greek or Italian bonds. They're buying safety -- an abstract concept not limited by the hard numbers in reality. Negative yields? Who cares, it's safe!

    The same could be said for gold -- investors aren't buying a yellow metal because it's useful for some purpose, they're buying safety. During the internet bubble, they weren't buying profits, they were buying hope and excitement. During the housing bubble they were... well, geez, I still don't know what the heck people were doing.

    But if investors are chasing after good dividends, that bubble deflates itself as the attractive yields fade.

    Am I perhaps overstating my case that desire for dividends couldn't get totally out of control and cause some sort of bubble-like occurrence? I can concede that. But I'll revisit that when investors are claiming Coca-Cola's 0.7% yield is fantastic because P&G is yielding 0.3%.

    With all of the other challenges that investors face right now, the last thing I think they should have on their mind is avoiding stocks that pay dividends because they're hearing there's a "dividend bubble."

    Matt

  • Report this Comment On September 27, 2012, at 10:33 PM, rjonesthree wrote:

    You say BPT represents a "place where investors can get themselves into trouble." What's your thesis? By my reckoning, the recent price drop caused by a WSJ article has created a good opportunity for higher yield and price appreciation.

  • Report this Comment On September 27, 2012, at 11:22 PM, Jellywig wrote:

    Matt, I think you make a good case for dividends. On a side note, I think I've seen some of your other posts on gold and my response with respect to this article is that you miss the bigger picture like Buffett does on gold. Is gold really about safety? Yes , to some degree, but this is black and white thinking. Gold is useful because it has value. Gold is useful because it has made me a lot of money in the last 9 years. Gold has been perceived as money for thousands of years and it will continue to. Why wouldnt it? It always comes back around historically because its tangible. And that's powerful, and that's useful. You are missing the party. How's your portfolio doing compared to Sinchy's?

  • Report this Comment On September 28, 2012, at 9:04 AM, ryanalexanderson wrote:

    Thanks Matt!

    I won't accuse you of semantics. But much of either argument is really about semantics anyway. I guess one could call "bubble" behavior and "seeking the illusion of security at any cost" behavior to be separate subclasses of "irrational" behaviour and just leave it at that.

    Thanks again for the comprehensive response.

  • Report this Comment On September 28, 2012, at 12:19 PM, TMFKopp wrote:

    @ryanalexanderson

    No prob! And yes, a lot of this really is semantics and involves the use of the term "bubble" WAY more often than it should be used.

    Matt

  • Report this Comment On September 28, 2012, at 12:35 PM, TMFKopp wrote:

    @Jellywig

    I don't want the discussion to veer off into a sidebar on gold, but it's probably a good reminder that I need to update my charts on gold to see where things stand.

    That said...

    "How's your portfolio doing compared to Sinchy's?"

    You know? I'm really not sure. Because for me, investing isn't a "whose is bigger" contest. It's about finding investments that I'm comfortable with and believe will earn a nice compounding return over time to help me retire down the road. Gold, a lump of metal that was used as currency prior to our current system, doesn't fit that category for me.

    I didn't invest in gold, but I also haven't invested in baseball cards, great works of art, or vineyards. I suppose you could say something similar about those. There are also a lot of stocks that have done well that I don't own. The best investors take a process-oriented rather than a results-oriented approach. Get the process right and results follow.

    Matt

  • Report this Comment On September 28, 2012, at 12:46 PM, TheDumbMoney wrote:

    I too object to the use of the term "bubble." The only thing we can be sure of is that there is a bubble in the use of the term "bubble." Bubbles are frigging everywhere, it's like I'm in living in a champagne flute. "Identifying" a bubble or yacking about one seems to be a guaranteed way for mediocre analysts to get themselves on TV and for mid-level financial managers to garner greater exposure for themselves, in lieu of producing actual great returns. In short, every time I hear someone mention a "bubble" lately I want nothing more than to smack them with dead fish.

    I do however think it is possible that certain stocks, such as potentially MO, T, KO, Sysco, and others, are modestly overvalued on a free cash flow basis, relative to the market, and that this overvaluation exists because of a lack of appealing bond-income options, their perceived safety, and their dividends and dividend growth. My CAPS pitch for ISRG indicates I started thinking this might be so in mid-2010, long before the media in general were suggesting it, and long before everything and its dog became a "bubble." There is always some premium paid for safety, and admittedly KO's P/E is not what it was in 1999, but right now there is arguably a particularly high premium being paid here for safety and yield, relative to the rest of the market. This is not a "bubble" by any means, but from a pure valuation perspective using discounted free cash flow I don't see a wonderful dividend stock like KO or Sysco outperforming the market over the next ten years. I could always be wrong, I often am, but that's just how I see it. (A wonderful dividend stock like Intel or Microsoft is an exception, because at this point everyone is convinced that every single big tech company is three inches away from going the way of Palm and now RIMM.)

  • Report this Comment On September 28, 2012, at 12:57 PM, NickD wrote:

    I invest in things like diapers,soda,burgers,toothpaste,shoes you know things people will always buy but not gold I wouldn't feel to good about owning gold.

  • Report this Comment On September 28, 2012, at 4:41 PM, Jellywig wrote:

    The great thing is you can buy diapers etc with gold if you had to - thats part of the point. It will be worth more than the dollar....

  • Report this Comment On October 02, 2012, at 9:44 PM, cashforever wrote:

    I know I'm a couple days late on this but I think there are some obvious points to be made here. A dividend bubble is unpossible if you compare the nature of dividend stocks to the nature of say tech stocks in the late 90s and residencial real estate from 2001-2007. Quality divi companies (there are quite a few) that have been paying steadily increasing dividends for over ten years are great investments. Period. Especially if you look at the dividend to price ratio and buy at the desired yield. The unpossible part comes into play at this point because if the stock price is soaring then the yield will stink, and it will no longer be a dividend bubble (people wouldn't buy a 1% yield). KEY WORD here was companies that *STEADILY* increase their dividends.

    Yeah Gold, that has some serious bubble potiential and it seems it could start a decline at any moment (sure if you want to look at ancient history, that's fine, hope you don't mind waiting 20-50 years for real returns because that would just be a blink of an eye for gold RIGHT??).

    Investing in companies with a healthy dividend is a great investing stategy. Sure, there will be some bad apples but overall it is "UNPOSSIBLE" for there to be a bubble in that regard. Cheers.

    P.S. Obviously watch out for companies that are boosting their dividend as their stock price tumbles.

  • Report this Comment On October 04, 2012, at 11:55 AM, mhbmeb wrote:

    For people wanting some extremely detailed info on BPT, I recommend reading http://seekingalpha.com/article/856641-bp-prudhoe-bay-trust-.... This is a highly complex valuation and you really have to pay attention to all the details. The article that started the BPT slide in August failed to take into account many of these factors and IMO was a bit misleading. There are several articles out there attempting to take on this complex valuation and I'd recommend reading them all before dumping your BPT, particularly if you've held it awhile. There's no indication that dividends will decrease for a long time from what I've seen.

  • Report this Comment On December 20, 2012, at 12:50 PM, naughtyguy wrote:

    It might be useful to read what Citron has written about GNI.

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