The traditional approach to investing in dividend-paying stocks has been to focus on the highest yielding shares in the market, which tend to be found in traditional groups such as utilities, energy, and telecommunications.
Yet those sectors account for just one fifth of all dividends issued by companies in the Standard & Poor’s 500 index.
What’s more, those stocks have soared 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.
To help you navigate today’s tricky dividend landscape, MONEY gathered several investment experts at the MoneyShow conference in San Francisco in late August to discuss smart ways to invest for income. 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 a few tips to help you balance the need for income with a desire to dampen risk as you approach retirement.
Get over your bias for blue chips
For years dividends were the realm of large, mature businesses and were anathema to young, rapidly growing enterprises. Yet as demand for income has grown, more and more small and midsize companies have begun issuing payouts too. Today 307 of the 600 stocks in the S&P small-cap index throw off income. That’s up more than 20% from two decades ago.
The broader universe of payers gives you the ability to avoid paying excessive prices for your dividends. Right now, Ablin says, “midcaps are priced at a discount to large caps, largely because they’ve already endured the profit margin compression that large caps are facing right now.”
Ablin gauges valuations by looking at price/sales ratios, which are similar to P/Es but measure stock prices against revenues, not profits. Today midcap shares sport a P/S ratio of 1.2, which is close to their historical median level. By contrast, large stocks are trading at a P/S of 1.9 on average, roughly a 25% premium to the norm.
“You do have to be careful,” Ablin says. “As a group, midcap payout ratios are starting to exceed that of large stocks.”
A company’s payout ratio represents the percentage of its earnings that are returned to shareholders in the form of dividends. A low reading implies that the firm has ample room to boost its dividends in the future without stressing its finances. On the other hand, businesses with close to a 100% payout ratio may be straining—or in some cases, borrowing—to maintain those payments. That’s a red flag.
Over the past decade the payout ratio for midcap stocks has been about 15% lower than for large, blue-chip shares. Today, however, the payout ratio for midsize stocks is nearly identical to that of companies in the S&P 500 large-stock index. But it’s important to note that the ratio is still under 40%, according to FactSet. Moreover, the figure is exaggerated by the 69% payout ratio for midcap telecom shares and the 1,100% ratio for midsize energy stocks, which suffered major losses amid falling oil prices earlier this year.
Your best move
Supplement your blue-chip dividends with a midcap fund—but one that isn’t overly exposed to the high payout ratios of energy and telecom. On our MONEY 50 recommended list, you’ll find WisdomTree MidCap Dividend WISDOMTREE TRUST US MIDCAP DIVIDEND FUND
. Unlike index funds that weight holdings based on market value, this ETF holds shares in proportion to the actual dividends paid. This gives the fund diverse exposure to all paying sectors.
And because the fund must lighten up on stocks where prices are rising faster than actual dividends—while buying shares of overlooked dividend payers—it has a pronounced value tilt. “It’s simply a fact: More expensive stocks have lower future expected returns,” says Gannatti. It’s also a fact that this fund has beaten 99% of its peers over the past decade.
Follow the money…overseas
While international stocks have been paying big dividends for years, Americans have traditionally preferred domestic payers, in part for the reliability of payouts. “There’s a stigma attached to companies in the U.S. cutting their dividends,” says Ablin. “Overseas, dividends haven’t been as sacrosanct.”
That’s starting to change, Freeman argues. Among larger, established firms abroad that are attracting global shareholders, including from the U.S., “management is starting to realize their investor base has shifted and now wants those dividends to continue,” he says.
In addition to higher yields, foreign payers come with several advantages. For starters, many foreign companies have recently been increasing their dividend payouts at a faster clip than American firms, which have been mired in an earnings drought. And after one of the longest bull markets in U.S. history, American stocks have gotten frothier. Foreign equities are now trading at a 16% discount to domestic shares even though they have historically enjoyed similar valuations.
Finally, U.S. firms spend less on dividends than on share buybacks, but that’s not the case abroad. “Internationally, there are far less share buybacks than dividends,” says Gannatti. “And in the emerging markets, it’s even less,” which leaves more money to be returned to investors.
While many high-quality dividend stocks can be found outside the U.S., “don’t lose sight of the fact that they bring with them foreign-currency exposure, which can bring volatility to your portfolio,” Freeman says.
Indeed, Vanguard recently studied the effects of exchange rates on foreign equities and found that currency exposure boosts an international stock fund’s overall volatility by about 15%.
Calculator: What is my risk tolerance?
Your best move
If you’re a decade or more from retiring, you can probably tolerate the added rockiness. So add foreign payers to your mix—up to about a third of your dividend portfolio. International shares are expected to yield 3.5% over the next decade, vs. just 2.1% for U.S. blue chips, according to the investment-consulting firm Research Affiliates.
In the MONEY 50, go with PowerShares International Dividend Achievers (PID), an index fund that tracks foreign firms that have boosted annual cash dividends for five years or longer. The fund, which yields 3.8%, has beaten 99% of its peers over the past decade.
But investors close to calling it a career need to play it safer. “The point about currency exposure is an important one,” Benz says. “Once you get into retirement, we really back off that foreign allocation quite a bit for older investors.” There is an alternative to cutting overseas exposure at this stage. Within five years of retiring, shift to a fund that hedges its currency bets. A good choice: iShares Currency Hedged MSCI ACWI ex.-U.S. ISHARES TRUST CURRENCY HEDGED MSCI ACWI E
, which currently yields 2.9% and charges just 0.35% in annual expenses.