Wednesday, September 9, 2009

Not all dividend stocks are overvalued

While the market has enjoyed impressive gains ever since it hit a multi year low in March 2009, investors are beginning to get nervous about valuation. If valuation is too high, chances are that investors are overpaying for stocks purchased, which could lead to lower performance over time.
Luckily however, the rally off of March lows has been lead by speculative names from the financial sector. Most of the high quality names that dividend investors follow, such as Johnson & Johnson (JNJ) or Pepsi Cola (PEP), have mainly followed the market higher in its ascend. If we were truly in a new bull market however, then we should expect that most investors would switch to quality blue chip companies. Another positive part is that stock prices are still lower, in comparison to their levels in September 2008.

While entry price does matter, defensive dividend investors should also look at the dividend coverage and the company’s ability to grow the distributions over time. Only after these two prerequisites are met, should investors begin evaluating companies with at least a decade long histories of dividend increases on the basis of valuation.

A minimum requirement for yield should also provide an adequate margin of safety in dividend income to investors in the event that the timing of the purchase was not correct in the short term. Even if the stock price stays below the entry price of dividend investors for a prolonged period of time, they would still be in a position to get paid to hold the stock. Enterprising dividend investors might even be able to re-invest distributions at lower prices.
In addition to that, if the company manages to keep raising distributions even during economic downturns, then it should also be able to increase dividends during economic rebounds. Thus, one could reasonably expect that share prices would increase during a bull market.

I have listed several dividend stocks, which are not overstretched. They are mostly dividend achievers and aristocrats. These are some of the positions I have added to most recently.

Abbott Laboratories (ABT) manufactures and sells health care products worldwide. The company has raised dividends for 37 years in a row. Abbott currently trades at 13.30 times earnings and yields 3.50%, with an adequately covered dividend. (analysis)

Automatic Data Processing, Inc. (ADP) provides technology-based outsourcing solutions to employers, and vehicle retailers and manufacturers. It operates in three segments: Employer Services, Professional Employer Organization Services, and Dealer Services. The company has raised dividends for 34years in a row . Automatic Data Processing, Inc. currently trades at 14.70 times earnings and yields 3.40%, with a sufficiently covered dividend. (analysis)

The Clorox Company (CLX) engages in the production, marketing, and sales of consumer products in the United States and internationally. The company operates through four segments: Cleaning, Lifestyle, Household, and International. The company has raised dividends for 32 consecutive years. Clorox spots a P/E ratio of 15.50 and yields 3.40%. (analysis)

Emerson Electric Co.(EMR), a diversified global technology company, engages in designing and supplying product technology and delivering engineering services to various industrial and commercial, and consumer markets worldwide. Emerson Electric has raised dividends for a record 52 consecutive years. The company trades at 15.3 times earnings, has an adequately covered dividend and yields 3.50%. (analysis)

Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. Johnson & Johnson has raised dividends for a very impressive 47 consecutive years. The company trades at 13.3 times earnings, has an adequately covered dividend and yields 3.20%. (analysis)

McDonald’s Corporation (MCD), together with its subsidiaries, franchises and operates McDonald’s restaurants in the food service industry worldwide. McDonald’s Corporation has raised dividends for 32 years in a row. The company currently trades at 14.90 times earnings , has a very well covered dividend payments and yields 3.60%. (analysis)

Just because a company has raised distributions for a long period of time however, this doesn’t mean that the current yield is going to be excessive. It is the fat yield on cost that long-term dividend investors are after. Also remember that companies cannot control its yield, which is a function of the stock price. Companies could however maintain a proactive dividend policy, where they strive to continuously raise distributions year in and year out.

Some dividend investors also completely ignore capital gains in the equation. While it is true that dividends typically account for 40% of the average annual stock market total returns, it is important to note that the remaining 60% have come from capital gains. The companies listed above not only have adequately covered dividend payments and decent current yields, but they also have strong capital appreciation characteristics.

Full Disclosure: Long ABT, ADP, CLX, EMR, JNJ, MCD and PEP

Relevant Articles:

- Six things I learned from the financial crisis
- Dividend Stocks Showing You the Money
- Dividend Reinvestment is important
- Reinvest Dividends Selectively

Popular Posts