Dividends are a powerful way to provide income, and low-risk, cash-rich blue chips should be a crucial part of your portfolio. However, investors need to wake up and realize that dividend stocks ain’t all they’re cracked up to be right now. The fact is some high-yield stocks are incredibly crowded trades — and you likely are buying a top if you invest now.
In fact, your worst investments in 2012 could be some big dividend names you’ve been fooled into thinking are safe.
Consider the outperformance of utility stocks in 2011. As risk-averse investors shunned volatile equities and avoided paltry Treasury yields, the income potential and stability of utility stocks attracted quite a few buyers. After all, what’s not to like? These are legalized monopolies with captive customers, and politicians and regulators ensure that they are going to stay that way. You can set your watch to the revenue!
The problem, however, is that everyone and their brother is now hip to the utility sector. The Utilities SPDR ETF (NYSE:XLU) is up almost 3% from the market’s July peak. The S&P is down about 9%. Some individual utilities have done dramatically better than that, too. Southern Company (NYSE:SO) and Consolidated Edison (NYSE:ED) are both up by about 11% since late July!
That’s nice if you bought in this summer, but a big warning sign if you’re thinking of buying utility stocks right now. It’s just not logical to think the share appreciation has come from growth — because the same business model that makes utilities bulletproof, stable investments also prevents them from ever seeing significant jumps in revenue or profits. It’s not like ConEd is going to start providing electricity to the Southeast to double its customer base or Southern is going to be able to charge 75% more for its service.
In short: The upside for utility stocks has already been had. Consolidated Edison and Southern both have a forward P/E of over 16 — higher than the S&P average — despite the fact they are in a slow-growth sector. Sure, a 4% dividend is nice … but shares could easily lose more than that once utilities fall out of favor and investors move their money elsewhere.
Another risky dividend investment is tobacco stocks. Customers are addicted, promising built-in demand, and strict regulations and low-growth prospects mean it’s next to impossible for any new competitors to pop up. The revenue is a sure thing — and so are the plump dividends as a result.
The performance is the same as utilities. Since the market’s crash in July that sent the S&P 500 down 9%, Philip Morris (NYSE:PM) and Altria (NYSE:MO) are both up by about 11%. Reynolds American (NYSE:RAI) is up almost 8%.
But come on, do you really think cigarettes will all of a sudden become healthy in 2012 and win over legions of new smokers? Or that statewide smoking bans will be lifted, advertising regulations axed and exorbitant excise taxes rolled back?
I don’t mean to malign the income potential of dividend stocks. However, investors need to be more discerning than just chasing yield. If you really want income and stable investments but want to avoid the overbought utility and tobacco sectors, consumer staples might be a better bet — and some like Hershey (NYSE:HSY) could actually see growth if the broader economy turns a corner. The confectioner yields 2.3% and is trader Jon Markman’s best stock to buy and hold for 2012 because it’s a shelter amid the euro zone nonsense.
There certainly is a lot to be said for investing in dividend stocks with reliable revenue. But just remember that low-risk doesn’t mean no-risk, and a nice yield might not offset the losses if your shares make a big move down.
Jeff Reeves is the editor of InvestorPlace.com. Write him at email@example.com, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook. Jeff Reeves holds a position in Alcoa, but no other publicly traded stocks.