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Thursday, September 27, 2012

That Dividend Trade is Getting Very Crowded

If there is one current conventional wisdom in the investing world it's investing in dividend or "dividend growth" stocks. It's not hard to figure out why: dividend yields above treasury yields, a need for cash flow and disappointing returns on the US overall equity market over recent years.

In fact strategies represented based on dividend weighting with reliable data (such as backtesting of formulas used in etfs like VIG and SDY) show some outperformance vs market cap weighted indices, as does performance of some large cap stocks that frequently show up on dividend screens. Furthermore this has been the case in recent years, even the utility index (XLU) was a star last year top performing sector for the first time in the last 50 years.

And many investors seem to be using the dividend flows as a substitute for bonds in their portfolios. Despite the cogent arguments against equating dividend stocks with bonds (like this one from Vanguard) the view persists. As I will point out in a future article they might be much better up expanding their horizons and constructing a portfolio of bond ETFs covering a mix of durations and credit risk to create their cashflows...and diversification.

Beyond those factors is another issue...the trade is getting very crowded. I found this chart in a recent research piece from Fidelity. They used it as an argument for investors to continue to buy dividend growth stocks because of growing demand. I view it as a sign of a crowded trade.

The picture is similar on the ETF side. Despite meager inflows into equity ETFs overall
Dividend ETFs remain popular as investors prefer funds that offer above-average yields and conservative strategies for exposure to the stock market.

A hot new dividend ETF from ishares HDV has amassed over $2 billion in assets in less than a year. A July Morningstar article noted the following...and there has been no sign the trend has slowed down since then.
Dividend-themed exchange-traded funds have been a popular choice among investors over the past year. The 42 dividend-themed ETFs that we follow raked in $16 billion in flows, nearly a third of every dollar going into equity ETFs, despite the fact that they make up just 5% by count of the 812 equity ETFs available. 

The above is a bit ironic since HDV uses a stock screen created by and licensed from Morningstart to pick its holdings.

What does that mean: a category that has been known for relatively low valuations (often considered "large value stocks) with low volatility has begun to carry valuations closer to that of "growth" stocks. Not surprisingly the very strong above market performance of last year has started to reverse itself, particularly during the market rally.

Here are returns for VTI (green,total stock market) and VUG (blue, large cap growth) vs  fast growing (in assets) Dividend ETF HDV (gold)year to date. Chart shows growth of $100,000.

  Ultimately dividends must come from either earnings growth or increasing the dividend payout. Based on the metrics below it seems that investors in some very popular dividend stocks are paying a very high price for those earnings. In fact those looking for dividends might well turn their sights outside the US...more on that in a future blog.

Here are some valuation measures of the top five holdings in HDV(courtesy of I'm not exactly how the current numbers can in some cases beabove the 5 year numbers. As a point of comparison the current p/e of the Vanguard large cap growth ETF has a p/e of 16, the S+P 500 14.
                      current p/e         5 yr p/e high      5yr avg p/e

ATT 51.5 48.4 20.5
Pfizer 18.4 19.3 13.4
JNJ 21.9 19.5 15.6
PG 18.9 17.9 15.2
Verizon 45.1 30.6 29.2

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