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  2. Dividends

How to Navigate Today's Treacherous Dividend Market

By:
Paul J. Lim
6 min read
- Stuart Minzey—Getty Images
Stuart Minzey—Getty Images

For income-starved investors frustrated by ultra-low bond yields — 10-year Treasuries are paying only 1.5%, 4.5 percentage points below the 60-year average — it's only natural to turn to dividend-paying stocks for relief.

Yet so much money has flowed into these shares lately that risks are soaring. "The traditional high-yielding theme is played out," says Jack Ablin, chief investment officer of BMO Private Bank.

In more ways than one. Lofty valuations aren't the only issue income investors face today. There's also the changing makeup of dividends themselves.

Two decades ago dividends were concentrated in a handful of slow growing sectors such as utilities, which were yielding more than 5%. Today utility stocks pay less than 3.5%. Meanwhile, tech companies—which for years refused to return profits to shareholders—have become the second-biggest contributor to overall dividends. And other fast-growing stocks here and abroad are also starting to embrace dividends.

To help make sense of this new world order, Money gathered several investment experts at the MoneyShow conference in San Francisco in late August to discuss smart ways to bring your dividend portfolio into the 21st century. "What you want to do is reflect the current reality in dividend-paying stocks," says Christopher Gannatti, associate director of research at WisdomTree.

The pros — Christine Benz, director of personal finance at Morningstar; Mark Freeman, chief investment officer at Westwood Holdings Group; Ablin; and Gannatti — came up with new rules to help you balance the need for income with a desire to dampen risk as you approach retirement.

You Have to Go for Income and Growth

The traditional approach to dividends has been to focus on high yielders. Today that creates a portfolio that pays more than 3% but that's concentrated in three areas: utilities, energy, and telecommunications. Those sectors account for just 20% of all dividends issued by companies in the Standard & Poor's 500 index, according to S&P.

What's more, those stocks have soared by double digits this year as investors frustrated by low bond yields have turned to equities for income. The result: Utilities are trading at a price/earnings ratio of 17 based on projected profits, a 20% premium to the sector's historical average. The energy sector's 55 P/E is more than triple its historical norm.

Read: The Best Way to Invest in Dividend Stocks

Also keep in mind: "Some of these higher-yielding stocks are interest-rate-sensitive," says Morningstar's Benz. She notes that when rates rise, which could happen later this year, "utilities start behaving like the bond market," meaning their value is likely to fall as market yields climb. Indeed, when 10-year Treasury yields went from 1.7% in February 2015 to 2.5% five months later, utility shares plummeted 14%.

The challenge

Normally, when investors sour on high yielders, they turn to the other extreme by focusing on companies paying only modest dividends now but whose payouts are rising. This dividend growth strategy directs investors to flashier parts of the market, such as technology and health care. The problem is, "there's also been a mania for dividend growth" in recent years, Benz says. That's in part because dividend growth stocks have outpaced the broad market by nearly one percentage point a year over the past decade. Plus, after the tech wreck and accounting scandals of the early 2000s shattered trust in Wall Street, "investors were in "show me the money" mode," she says. And companies were forced to comply.

In the past 49 quarters the S&P 500's annual dividend growth was 10%, Benz says. That's double the pace since 1900. The rate fell back to 4.6% earlier this year. And since earnings growth has declined for five quarters, it's unlikely that dividend growth will rebound soon.

Read: Chasing Dividends Is a Risky Investment Strategy

Your best move

Rather than investing strictly for either yield or dividend growth, "a mix-and-match diversification strategy is the sensible approach," Benz says.

You can do that through a value-minded fund like Schwab U.S. Dividend Equity ETF , she notes. The ETF tracks an index of large U.S. stocks that have paid dividends for the past 10 years and are strong on profits, cash flow, dividend yield, and dividend growth. As a result of this balanced approach, Schwab U.S. Dividend has exposure to all industry sectors, which is important because every sector now contributes to dividend payouts.

The fund, which charges only 0.07% in annual expenses, has also beaten three-quarters of its peers over the past three years while offering investors a smoother-than-average ride.

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