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

Brian Stoffel
February 13, 2012

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