Tuesday, October 22, 2013

Investors Are Paying A High Price for Dividends

Picture1
courtesy:  Mebane Faber Research
Most Wall Street strategists agree on the overvaluation of high dividend paying stocks.

One of the more obvious sectors that seem vulnerable would be the utility group.

The fundamental outlook for much of the utility industry looks weak, in my opinion.

Investor demand for companies that pay above-average dividends from a relatively stable source of earnings has spurred the utility sector to near-record high valuations:
 


Meanwhile, the industry is facing challenges on many fronts.

Growth in electricity use has been tepid, despite most improvements in the economy.

If interest rates rise next year, as many expect, utilities will fare poorly.  Higher bond yields would present stiff competition to utility stocks.

Regulators are looking hard at the utility allowed rates of returns, and in several cases have already pushed returns lower.

Capital demands to meet new environmental standards has also been high in recent years.

Finally, the price of alternative energy sources (notably solar) have fallen dramatically in recent years, making cleaner generating power competitive with traditional sources.

I asked UBS's electric utility analyst Julian Dumoulin-Smith yesterday if there is still a bull case to be made for his group.

As a group, no, Julian responded. 

There are a few special situations that might be interesting.  He likes Northeast Utilities (ticker: NU) due to its strong position in transmission.  He also likes Duke Energy (ticker: DUK) due to its friendly regulatory environment, as well as the coming divestiture of Duke's Ohio generating operation.

But in general Julian was unenthusiastic about the stocks in his group.

That said, it is not just the utility sector that is trading at historically high multiples.  Many consumer staples stocks, as well as a few telecommunications stocks, are also trading at relatively rich valuations due to their attractive dividend yields.

Take a look at the chart above courtesy of Mebane Faber research.  Dividend stocks all generally screen as unattractive yet investors do not seem to care.

For now.