More Proof That There Is No Dividend Bubble

An article I wrote yesterday boldly stated that there is, in fact, no "dividend bubble." My fellow Fool Morgan Housel doesn't see it that way.

"I didn't quite agree with your reasoning," he messaged me. "For one thing, a lot of yields are at abnormal lows." He went on to cite the fact that Philip Morris International (NYSE: PM  ) has an unusually low dividend yield, as do utility companies Consolidated Edison (NYSE: ED  ) and Southern Co. (NYSE: SO  ) .

Morgan is one heck of an analyst, but there was no way I was about to let him get away with shrugging this off based on a few anecdotal examples. It was time to gather some data.

On the whole
I'll start with one bit of evidence that could be seen as supporting Morgan's stance. If we look at the S&P 500 companies that had a dividend yield of 3% or more three years ago (bubble 1 in the chart below), the median price increase on those stocks has been 43.5%, and their current median price-to-earnings ratio is 18.2. Comparatively, among all stocks in the S&P 500, the median gain has been 37.9%, and the current median P/E is 17.4.

So the stocks that had a 3%-or-better dividend have outperformed the overall S&P and are currently trading at a higher price. The extent to which they've outperformed and the difference in valuation is hardly worthy of the title "bubble," but I don't want to completely deny Morgan here.

That said, it's a different story when we look at all of the companies in the S&P 500 that paid a dividend three years ago (bubble 2). That group has had returns in line with the overall S&P and has a current P/E ratio below the broader group. So it would appear that investors weren't simply after any dividends; they were going for higher dividends. And because higher dividends can often be a signal of undervalued stocks, perhaps all we saw with the group that outperformed the S&P was the fact that they started the three-year period undervalued.

More importantly...
A key to the argument in my article yesterday was that because dividend yields fall as stock prices rise, any sort of dividend bubble would cool itself down as rising prices pushed down yields.

And so when we talk about the potential for a dividend bubble, we should consider the stocks that investors would be looking at today because of their yields. Interestingly, among the stocks that currently sport dividend yields of 3% or better (bubble 3), the median P/E is 16.3, notably below the 17.4 of the overall S&P. Furthermore, over the past three years, that group has had a median return of 26.4% versus the overall S&P's 37.9%.

So in essence, the investors going after significant dividend yields don't end up picking crazed, inflated stocks, but stocks that look more like value-oriented picks. And that's in addition to the fact that they pay attractive dividends.

What about Philip Morris?
I can't really argue with the examples that Morgan provided. Yes, the yields do look somewhat low on Philip Morris, Con Ed, and Southern. But what does this tell us? Not a whole lot. Based on the data above, I hardly think we can conclude that there's a dividend bubble. In fact, it's hard even to conclude that there's a bubble in utility stocks or consumer staples stocks.

Over the past three years, utility stocks as a group (bubble 4) have underperformed the S&P, and they trade at a P/E that's a discount to the rest of the index. Sure, Con Ed has had a stellar run -- a 46% gain that has pushed its P/E close to 17 -- but PG&E has vastly underperformed the market, and its dividend yield has risen over the past three years. And the fact that Exelon paid a 4.2% dividend three years ago didn't save its stock from a 29% slide.

There are also some good examples on the consumer staples side. Philip Morris is up a whopping 90%, and its yield has fallen from 4.9% to 3.8%. On the other hand, Clorox has risen just 23%, and its dividend yield has climbed from 3.4% to 3.6%. Meanwhile, Procter & Gamble's stock is up just 20%, and its yield is up as well.

So where's that bubble again?
Over the past three years, 78% of the stocks in the S&P 500 have seen their prices rise. The median price gain has been 38% (45% on average). That means that many of the stocks we might look at have had solid performance over the past three years. Some of those stocks are dividend payers. So, yes, it's entirely possible for us to find certain dividend stocks that have gone up significantly in price and are not attractive buys today. But does this mean that we have a dividend bubble on our hands? Not so much.

If you think that I'm right and Morgan is wrong about this dividend bubble, I commend you for your shrewdness and wisdom. As a show of my appreciation, follow this link to get free access to a Motley Fool special report that dives into nine dividend-paying stocks that could be ready for prime time in your portfolio.

The Motley Fool owns shares of The Clorox Company. Motley Fool newsletter services recommend Exelon, Southern Company, and The Procter & Gamble Company. 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.

Fool contributor Matt Koppenheffer owns shares of Clorox 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.


Read/Post Comments (7) | Recommend This Article (59)

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 October 03, 2012, at 4:31 PM, Gorm wrote:

    Just don't see it. So many of these heavy dividend payers have had terrific appreciation. With so many economies contracting and so many companies forecasting uncertain futures, atop all the DEBT and UNCERTAINTY, this market will go eventually go down to reflect REALITY - erasing chased yields.

    JUST which, if any economies are improving? Even China is hurting (relatively) and they are not immune to bad debts, social unrest, etc.

    Just don't see it!

    This is a hyped market. Just received a newsletter today from a respected and conservative manager, who from my perspective, acknowledged the threats but was willing to follow the herd. That was enough of a signal to me to steer clear!!

    Gorm

  • Report this Comment On October 05, 2012, at 11:57 AM, whyaduck1128 wrote:

    I may be wrong, but it seems to me that there's an article every week with this title or a similar one.

  • Report this Comment On October 05, 2012, at 1:36 PM, Darwood11 wrote:

    Here's my take on this debate. If I assume there is a "dividend stock bubble" then I also should assume that at some point, such assets will experience a substantial decrease in value. Such a decrease will be excessive, as compared to other stocks in the market.

    So when or if the "dividend bubble bursts" one of two things will happen. Investors will flee dividend paying companies to..... what?

    In the other situation, dividend payers will find their stock prices as such lofty values that their dividend yield will be puny, or will be in a situation in which they cannot pay a dividend.

    Here's my 2 cents, which thanks to Bernanke, is worth less today than it was two weeks ago.

    Buy good companies that pay dividends, and hold them until they are no longer good companies, or until that company can no longer achieve the goals set by the stock purchaser (Kodak, for example) or until one sees a much better opportunity. By "hold" I mean, purchase with the intention to make a long term purchase.

    I realize that in the current parlance of "investors" that "long term" might be a few weeks. However, i am suggesting a "long term" of a decade, or more.

  • Report this Comment On October 05, 2012, at 3:01 PM, amckane wrote:

    I sold ED because I thought it was overvalued, then bought EXC. So far ED has drifted a bit higher and I am taking a 10% hit so far on EXC. Once people get over that fear of nukes they will warm up to EXC, which will then (I think) outperform ED in the next decade.

  • Report this Comment On October 06, 2012, at 7:10 PM, dsciola wrote:

    Interesting article, thoughts either way.

    Dunno if I agree with the statement "higher dividends can often be a sign of "undervalued stocks." Value is determined by earnings and cash flow in my opinion, not dividends.

    Just my slightly less valuable 2 cents, thank yu bernake.

    Dom

  • Report this Comment On October 08, 2012, at 2:41 PM, BigAl1825 wrote:

    Dividends are paid out to reward stockholders and encourage more stock purchasing. In effect, dividends are bubble creators, if we synonymize bubble with "investment." Of course, a bubble usually means overinvestment, but only in retrospect. Had banks had their houses in order a few years ago we might not be talking about the collapse of the "housing bubble." Usually a bubble implies some sort of collapse.

    So the question, properly framed, is whether current market conditions are such that people are overinvesting in dividend-paying stocks that will eventually collapse and create big losses for the investors.

    Does anyone really believe that if another collapse comes it will be because people were chasing too many dividends, and not because of any of the geopolitical, socioeconomic factors that affect the markets?

    If, instead of "bubble," what is meant that dividend-paying stocks are relatively expensive compared to other investments, then we aren't talking about bubbles, we're talking about what is the best investments. There is a difference.

  • Report this Comment On October 09, 2012, at 9:40 PM, NickD wrote:

    INTC is down 2.71%

    JNJ is down 1.48%

    WMT is down 1.48%

    HD is down 1.50%

    MSFT is down 1.68%

    I bet by weeks end if not tomorrow there all gonna be up w/e they were down and ill be the much richer

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