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Private equity investors are borrowing money to pay themselves dividends.


There's no denying the attraction of dividend stocks. ETFs and mutual funds with a dividend focus have been pulling in a ton of money over the past 12-18 months, in large part as investors search high and low for income. With bond yields so low, investors are seeking alternatives in equity dividends. In fact, dividends have become so popular, that some analysts and market watchers wonder whether dividend stocks have entered "bubble" territory.

I tend to roll my eyes whenever I see the "b" word being thrown around. Quite frankly, it's overused. At some time or another over the past couple of years, it seems gold, commodities, real estate, emerging markets, and a variety of other assets have all been described as being in a "bubble." In reality, a market bubble refers to some very specific economic and market conditions heralded (in part) sometimes by rampant speculation, irrational valuations and extreme boom/bust cycles.

So let's answer that one right off the bat: are dividend stocks in a "bubble"? No. Are they overpriced? Well, that's an entirely different question.

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Judging from the data I've seen over the past little while, dividend stocks are getting pricey. In fact, high-yield stocks (that is, stocks with dividends 20 per cent or more higher than the overall S&P 500) are trading at a modest premium to the broader-based U.S. market. (Historically, they trade at something like a 20 per cent discount.)

You can see that premium at work by comparing two well-known, very liquid U.S.-based ETFs. The SPDR S&P Dividend (ticker SDY) tracks the S&P Dividend Aristocrats Index. It has a trailing price/earnings ratio (P/E) of 17.1, and a forward P/E of 15.3. Compare that with SPY which tracks the broader S&P 500 Index: it has a trailing P/E of 15.4 and a forward P/E of 14. So right there, as measured by price/earnings ratios, the dividend ETF is more expensive.

What makes it even more expensive is that the stocks in SPY have an estimated three-to-five-year EPS growth of 10.5 per cent, whereas the growth rate of the stocks in SDY is only estimated to be 8.4 per cent. Long story short: investors are paying more for higher-yield, lower for growth stocks.

Another issue to consider is high-yield stocks' share of the overall market. Consider the chart I came across recently (to the left of the text, in the sidebar).

You can see that about 45 per cent or so of the market is made up of stocks with yields 20 per cent above the market average. That percentage is well above the historical average, which is about 36 per cent. The last time they reached this level was way back in 1981.

By no means am I a technical analyst; a chart can tell you a lot of things, but it can't predict the future. That said, I get wary anytime I see one industry or asset class come to dominate the market like this. If anything, I think it suggests that high-yield stocks are vulnerable if a market pullback happens.

Don't get me wrong: I'm not anti-dividend. I think investing in dividends makes a lot of sense. It's a good way to get tax-advantaged income–always a good thing. I also think dividends are a pretty good first-level screen for equities. Simply put, dividends have a tendency to keep management honest. When you know you have to cut a cheque to shareholders every quarter, there's less inclination for empire-building and more inclination to be prudent with cash.

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If you're currently holding a portfolio of high-quality, blue-chip dividend stocks because you're a conservative, growth-oriented investor, then all this talk likely means relatively little to you. But if you're just entering the space–if you're thinking of buying dividend stocks right now–you might want to wait. The continuing flight to safety (and income) that we've seen over the past several years have made these kinds of stocks (and the ETFs and mutual funds that invest in them) very popular right now. That's usually a sign that the timing isn't right.

One final point I'd like to make when it comes to investing in dividend stocks: dividends are all well and good, but dividend growth is usually better. That is, how fast is the dividend growing? By how much? And what's the dividend payout ratio: that is, how sustainable is the dividend now, and how much more room does it have to grow over the next three, five, 10 years?

These are particularly important questions right now, as investors stretch for yield. Stocks with high current dividends are probably overpriced – not a bubble, mind you, but definitely expensive. Stocks with a lower yield, but a compelling record of dividend growth are less expensive. Seeking out those dividend growers rather than dividend payers may be a better strategy in today's climate.

Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as portfolio manager and director, wealth management. Thane is also Managing Director forTIGER 21 Canada. He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)' The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.

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