Shares of high-quality, cash-rich, large-cap companies that yield more than the Standard & Poor's 500 Index ($INX) are the new favorites in many portfolios. But many of these success stories have been discovered, boosting share prices and trimming yields.
At this point, investors might do better scouring the S&P 500 for companies that wouldn't show up on a screen for above-average yielders, but which still enjoy dominant, "wide moat" positions in their business.
"It's kind of a crowded trade," said Paul Nolte, managing director at investment firm Dearborn Partners, about the popularity of the high-quality dividend strategy. "Valuations on high-dividend payers are at the upper-end of their historical ranges."
Indeed, money has cascaded into dividend-focused mutual funds and exchange-traded funds. iShares Dow Jones Select Dividend (DVY, news), for example, saw assets grow to around $10 billion from $6 billion a year earlier, according to the ETF Industry Association. Similarly robust asset growth was seen at Vanguard Dividend Appreciation ETF (VIG) and the SPDR S&P Dividend (SDY, news) fund.
It's easy to see why dividends are in demand. They're an alternative to bonds' paltry payouts, and they cushion volatility. Plus, these stocks offer potential for capital appreciation.
Without dividends, the S&P 500 was flat in 2011; including dividends the market returned 2.1%. The yield-rich Dow Jones Industrial Average ($INDU) fared even better, up 5.5%. And the 10 highest-yielding Dow components, the so-called Dogs of the Dow, returned 12.2%.
"Any time we see a big surge in the popularity of dividends in the market, that means prices have been marked up and it's tough to find bargains," said Josh Peters, editor of Morningstar's DividendInvestor newsletter.
Off the beaten path
Owning financially healthy companies that reward shareholders with meaningful income is certainly still a viable investment idea. Large-cap stocks with little or no debt, that pay consistent dividends, and which grow those payouts over time, have been excellent decisions. And 3% or 4% in cash payments every year is nothing to ignore.
Last year, for example, the average S&P 500 dividend payer gained 1.4%, compared to the average 7.6% decline for non-payers, according to S&P. Performance was even better for S&P's "Dividend Aristocrats" -- companies with that have boosted payouts for at least 25 consecutive years, such as AT&T (T, news), Johnson & Johnson (JNJ, news), McDonald's (MCD, news) and Procter & Gamble (PG, news).
Many investors now are hoping such dividend magic will apply to Apple (AAPL, news), which earlier this week reported blowout earnings. Apple's chief financial officer said the company is considering ways to be proactive with a cash hoard approaching $100 billion.
Apple isn't paying a dividend, but if it did, the dividend world would spin. "If Apple came out with a policy that was going to give the stock a yield of 4%, you bet I would look at it," said Morningstar's Peters.
But investing in a company that might pay a dividend isn't a solid approach; nor is buying the highest yield. Companies in financial trouble often sport unusually fat yields after the shares have taken a beating, and their ability to maintain the dividend is questionable.
Better to focus on dividend-paying companies in robust financial health, and then consider how that quarterly payment could grow. The dividend might not be terrific now, but a well-run operation with a high return on investment is often the kind of company given to dividend hikes. And dividend investing is a long-term strategy; the goal is to "clip coupons" year after year.
"Think in terms of what the yield could be, rather than what it is," said Don Taylor, manager of Franklin Rising Dividends A (FRDPX).
Ideally, these businesses boast a "wide moat," meaning they stand apart from competitors because they invest shareholder capital wisely, minimize borrowing, grow revenue streams through smart expansion, and retain cash-generating assets such as patents or other intellectual property.
It's also crucial that dividend investors choose companies with plenty of cash to cover the dividend -- derived from an earnings-based measure called the payout ratio.
Nowadays, with companies banking cash as a buffer against economic uncertainty, the average payout ratio of S&P 500 members is under 30% of earnings, compared with a historical 52%, according to S&P. One upside to this stinginess is that companies have room to loosen their purse strings. Howard Silverblatt, the senior index analyst at S&P, estimates that 70% of the S&P 500 payers will boost their dividends this year.
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