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David Hill's Analyst Insights

Options and ETF Analyst Writer
David G. Hill
Author Bio

September 10, 2012 - Can Dividend Seekers Get the Best of Both Worlds?

Have you heard? We could be in the middle of a dividend bubble? unless we aren?t. The worry du jour on the market posits that high-yield dividend stocks are overvalued, thanks to the investors who have poured money into these stocks over the past few years. With bond and treasury yields still historically low, a 2% (or more) dividend yield on a utility or consumer staple stock has become kind of a new safe haven. But could dividend payers like Altria (MO) or McDonald?s (MCD) be less safe than they appear?

A Motley Fool analyst recently pointed out that dividend-paying stocks in the S&P 500 are up just 1.3% this year, while the non-dividend paying portion of the S&P 500 is up 8.3%. This argument for a bubble is specious, though, conflating correlation with causation. A company begins paying dividends when the potential return from reinvesting income falls below its hurdle rate. That is to say that mature companies with steady cash flows (the kinds of stocks that don?t exhibit very fast growth) are also more likely to pay dividends. Just because dividend payers are growing more slowly than the rest of the market does not mean we are about to see those stocks crash.

If all financial bubbles share one characteristic, it is that (almost) no one sees them coming until it is too late (with a corollary: they all seem completely obvious in hindsight after they burst). Indeed, the contrarian case against a dividend bubble would cite the fact that observers are screaming about it as proof it does not exist (but a counterpoint of warning: plenty of people were warning of a social media bubble a few years ago, and the implosions of Facebook, Groupon, and other social media stocks are proof that those stocks were hugely overvalued).

But the talk about a potential bubble does highlight a major tradeoff investors make when investing in dividend stocks. Because those stocks are comfortable enough to give earnings back to shareholders, their room for growth is often limited. Investors like dividend stocks for their safety, but the reduced risk of these stocks also reduces the chance that they can make explosive returns. This dilemma is not new; investors have long sought a way to have their cake and eat it too.

Maybe there is a way for investors to get income-generating dividends with the prospect for growth. One possibility is buying the SPDR S&P 500 ETF (SPY), whose dividend yield is 1.9%. Because it is composed of both sleepy dividend payers like Dominion Resources (D) and AT&T (T), along with growing stocks like Apple (AAPL) and Wal-Mart (WMT), SPY can provide growth and dividend yields. But investors with a little more tolerance for risk could try out an emerging markets dividend ETF, taking advantage of economies growing much faster than that of the US. The iShares International Select Dividend ETF (IDV) is comprised of dividend-paying stocks based in developing countries. It yields roughly 5.5%, well above SPY?s yield.

Consider a January covered call on IDV at the $32 level for a net debit of around $31.02. That is good for a 3.1% return (8.7% annualized ? for comparison purposes only) and the trade has about 3.1% downside protection. IDV paid $1.62 per share in dividends over the past 12 months, giving it an annual dividend yield of 5.1%. But if you calculate the dividend yield using the net debit on this trade (since that is your actual cost), the yield comes out to 5.2%. Add that to the return on the covered call, and the annualized return on this trade comes to 13.9%.

IDV is showing bullish technicals. Standard & Poor?s gives the ETF a Marketweight rating. To get a 3.1% return on a simple long position on IDV, the ETF would have to rise to $33.01, a level it has reached since early April. IDV bounced off of support in the $31 range a few weeks ago and is testing new resistance around $32.

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