One of the most popular equity strategies for income investors over the past few years was buying dividend-yielding stocks.
Since interest rates have been at rock bottom after the 2008 credit crisis, income investors who normally would have bought bonds saw better yields in certain equity sectors, such as utilities and telecommunications.
But being a popular trade means that valuations are lofty, which makes it difficult to find bargains. This is the case not only for dividend stocks, but for equities in general since the various stock market indices sit at record highs. Combine that with the Federal Reserve beginning to raise interest rates, and investors may need to review their strategies.
[See: 20 Awesome Dividend Stocks for Guaranteed Income.]
That doesn’t mean that the dividend play is dead, market watchers say. It just means revisiting whether certain portfolio positions are short term or long term, and the purpose for holding.
Dividend investing is still viable. Jeff Zipper, managing director for investments, Florida, for the Private Client Reserve of US Bank in Palm Beach, says investors should still look at dividend stocks, especially if they have a long-term time horizon.
“Over time, half of the return of a dividend-paying stock is going to be the dividend yield,” he says.
Still, market watchers say, investors shouldn’t blindly buy any stock with a big yield and think it’s a safe investment. Valuations are heady, whether looking at price-earnings ratios for individual equities or considering that the various indexes are near all-time highs.
The current Standard & Poor’s 500 index price-earnings ratio is around 26.5, which is historically high. Going back to 1880, the ratio’s mean is 15.65, and its median is 14.65. Even with a shorter, more modern time frame, the Cleveland Federal Reserve said the average S&P 500 forward P/E ratio from 1990 to July 2015 was 16.5.
Valuations are especially high relative to history in the defensive sectors like utilities and staples, and also in other income-producing vehicles, such as real estate investment trusts and master limited partnerships, says Bradford A. Evans, senior vice president and portfolio manager at Heartland Advisors in Milwaukee.
“First and foremost, I would urge investors to be very mindful of valuation, because in those very defensive sectors that have been perceived as a safe harbor because of the yield component and the low volatility, there isn’t much of a valuation safety net in those equities,” he says. “Bad news can destroy a lot of capital appreciation in a hurry, which would make the income dynamic moot.”
John Person, president of NationalFutures.com in North Palm Beach, Florida, says investors need to look at their portfolios.
“With stuff at all-time highs, investors need to ask, ‘Can this path continue and what do these companies have to sell in order to continue up?'” he says.
[See: The 10 Best REIT ETFs on the Market.]
Will the Fed impact stocks? Investors should not be concerned about the impact on equities of the Fed raising interest rates because the central bank’s moves will likely be limited, says Robert R. Johnson, president and chief executive officer of the American College of Financial Services in Bryn Mawr, Pennsylvania.
“They’re early on in the tightening process, so there aren’t other options,” he says. “Fixed income isn’t yielding discerningly more than prior to the Fed move.”
Person says even if the Fed hikes rates a few more times at quarter-point increments, the short-term federal funds rate will be less than 2 percent.
“I don’t think they can raise fed funds to over 2 percent without throwing global markets in a tailspin due to interest rate differentials,” he says, referring to the zero to negative interest rates in Europe and part of Asia.
Even though the Fed’s moves might be steady, Zipper says investors may want to shift from “bond proxy sectors” like utilities and telecommunications and into some of the sectors that pass along the impact of higher rates. Investors should pay attention to the interest-rate yield curve and watch to see how longer-dated maturities perform versus shorter-dated instruments. So far, the longer-dated maturities haven’t see yields rise much, but if that happens, that could be a warning signal for income investors, he says.
What to do. Zipper says on a valuation basis, US Bank likes technology and health care sectors. Even though health care has been in the headlines because of changing presidential administrations and policies, the sector is “doing pretty well this year,” he says.
“That’s a sector that has the ability to raise dividends, at least certain parts of the sector,” he says. “[Technology and health care] are two we do like on a valuation basis. The have a relatively lower payout ratio than your bond proxy sectors.”
Evans says investors also need to stop looking at equities as income-generating vehicles and start treating them as capital appreciation, which has not been the case with the dividend plays.
“I would urge the retail investor to break the habit of investing in equity for yield,” he says. “Start looking for equities that have capital appreciation potential but possess a small current yield, a manageable yield 1 to 3 percent, but have the ability to grow that dividend as the economy continues to expand. Capital appreciation with dividend growers is the recipe that will work with the Fed raising rates.”
Person says having a portion in cash right now isn’t a bad idea, but for people who want to stay invested, he says there are still some undervalued companies in the energy sector.
A few names he likes are petroleum refiner Phillips 66 (ticker: PSX), as well as exploration and crude oil companies Hess Corp. ( HES) and Anadarko Petroleum Corp. ( APC).
[See: ETFs for Nervous Energy Investors.]
“Fossil fuel refiners aren’t bad at this time of year. I don’t think you’ll have a bad time and lose your [shirt] in that stuff,” he says.
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Do Dividend-Paying Stocks Still Make Sense? originally appeared on usnews.com
