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Are Dividend Stocks in a Bubble?

The flight to income stocks makes for higher prices

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A few years ago when I started my site I made a prediction that dividends might become the next big bubble in the making. After two stock market crashes, record low interest rates and the increase in the number of individuals who rely exclusively on their nest eggs for retirement, investors were bound to start chasing dividend stocks.

Over the past several months, I have read several articles discussing whether we are in a dividend stock bubble or not. Back in early January I mentioned that I did not believe we are in a bubble. I decided to join the conversation again, and provide my audience with a balanced outlook on things. I define a dividend bubble as a situation where investor expectations have pushed valuations beyond overvalued territory.

Some pockets in the market are indeed in a dividend bubble. High yield stocks such as utilities and REITs are trading at 52 week highs. Their yields are at multi-year lows. The problem with these stocks is that many tend to raise dividends at a very slow pace, because their earnings power does not increase by much over time. Due to the low interest rates, investors have simply chased these yield stocks which has led to decreases in yield. If inflation were to pick up, investors in utilities would be beaten up on three fronts — low initial yields, low dividend growth that fails to compensate for inflation and earnings which would suffer if inflation pushes interest rates back up.

For example, companies like Con Edison (NYSE:ED), which have been raising distributions by 1%  per year for the past 15 years are yielding less than 4% today. Given the low earnings growth, high payout ratios and lowest yield in decades, investors in this New York based utility might be in for a rude awakening a few years from now.

Other companies such as Coca-Cola (NYSE:KO) are trading at 20 times earnings. This is also overvalued territory, and investors who purchase stocks at high multiples are taking on a lot of unnecessary risk. Even the best dividend growth stocks in the world are not worth owning at any price.

In fact, one of the main reasons behind the lackluster performance of U.S. stocks since 2000 is the fact that they were grossly overvalued at the beginning of the millennium. Even such dividend growth stars as Coca-Cola and Johnson & Johnson (NYSE:JNJ) traded at absurd multiples. As a result, while earnings and dividends grew over the next decade, stock prices of these quality companies remained flat until they got into buy territory just recently.

There are also some companies that “look overvalued” to the naked eye. Companies like Johnson & Johnson appear to be trading at P/E ratios above 20. Dividend investors should focus on recurring earnings, while ignoring one-time charge-offs that do not affect recurring earnings.

For example, back in the fourth quarter of 2011, Johnson & Johnson earned only 8 cents per share. Adding the earnings for the next three quarters totals $3.04 per share. At current prices, this equates to a P/E of 23.30. If one takes the time to read the 4th quarter earnings release, they could see the following:

Fourth-quarter 2011 net earnings reflect after-tax charges of $2.9 billion, which include product liability expenses, the net impact of litigation settlements, costs associated with the DePuy ASR™ Hip recall program, and an adjustment to the value of a currency option and costs related to the planned acquisition of Synthes, Inc. Fourth-quarter 2010 net earnings included after-tax charges of $922 million representing product liability expenses, the net impact of litigation settlements, and costs associated with the DePuy ASR™ Hip recall program. Excluding these special items for both periods, net earnings for the current quarter were $3.1 billion and diluted earnings per share were $1.13, representing increases of 9.3% and 9.7%, respectively, as compared to the same period in 2010.

Adding back the $1.05 per share, and EPS comes out to $4.09 per share. But there was another one-time charge that JNJ recorded in Q2 2012:

Second-quarter 2012 net earnings include after-tax special items of $2.2 billion, consisting of non-cash charges primarily attributed to a partial write-down of in-process research and development and intangible assets related to the Crucell vaccines business, an increase in the accrual for the potential settlement of previously disclosed civil litigation matters, and transaction and integration costs related to the acquisition of Synthes, Inc. Second-quarter 2011 net earnings included after-tax special items of $772 million, consisting of net charges related to the restructuring by Cordis Corporation, the net impact of expenses related to litigation, DePuy ASR™ Hip recall costs, and a currency adjustment related to the acquisition of Synthes, Inc. Excluding these special items, net earnings for the current quarter were $3.6 billion and diluted earnings per share were $1.30, representing increases of 2.7% and 1.6%, respectively, as compared to the same period in 2011.

Without these one-time deals, earnings per share for Johnson & Johnson would have been $4.89 per share, which makes current P/E ratio to be 14.50.

In general however, dividend investing continues to be a stock pickers market. Investors who harvest the fruit of their income portfolios tend to spend some time screening the market for quality stocks at bargain prices, according to their predefined entry criteria. I still find companies trading at P/E ratios of less than 15 times earnings:

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