The Biggest Red Flag for Dividend Investors

Will dividend stocks keeping showing investors the money? Photo: via Flickr.

Stocks that pay dividends have risen in popularity over the past decade, as rock-bottom interest rates have punished savers who've favored traditional fixed-income investments like bank CDs and bonds. Yet even though most dividend investors see the stocks they hold in their portfolios as being low-risk, the popularity of dividend stocks has dramatically increased their valuations, and that poses a red flag for many risk-averse dividend investors who don't realize the potential for losses in their dividend portfolios.

When defensive stocks don't workMost investors who gravitate to dividend stocks do so because of the unique combination of attributes they offer. On one hand, dividend investors rely on the steady stream of income that their stocks provide, as the income often serves as a stabilizing force on share-price movements to reduce their volatility even in violent market moves. On the other hand, the best dividend stocks also have potential for growth, and that can result both in higher share prices and in boosted dividend payments in the future.

Source: Tax Credits, Flickr.

Many dividend payers also have a reputation for being defensive stocks, meaning that they outperform during down markets. Historically, dividend stocks have done a good job of avoiding the full extent of losses during troubled times, especially those whose businesses are tied to industries that aren't as vulnerable to cyclical swings. In large part, that's because dividend stocks tend to lag behind in bull markets, as investors gravitate more toward the high-growth, high-risk cyclical companies that benefit so much during good economic times.

McDonald's has faced major challenges lately. Source: McDonald's.

High valuations for blue chipsThis time around, as the market has climbed, blue-chip dividend stocks have seen their valuations climb to what many see as unsustainable levels. Even companies whose growth prospects remain in question fetch healthy multiples to their earnings. McDonald's , for example, is struggling with problems overseas as well as heavy competition in the U.S. fast-food market, and most analysts expect overall sales at the company to fall both this year and next. Yet in large part due to its 3.5% dividend yield, McDonald's stock sells at 20 times its annual earnings.

When you add in stocks that have even minimal growth prospects, you can see even bigger multiples. Coca-Cola has had trouble with its core carbonated soft-drink business, but it has had greater success with still beverages as well as with its partnerships with Keurig Green Mountain and Monster Beverage. Yet at 25 times earnings, Coca-Cola stock looks quite pricey. Similarly, Procter & Gamble has suffered from the strong dollar and its impact on its international sales, yet it also carries an earnings multiple of 25.

The other thing to keep in mind with dividend stocks is that some of their popularity has stemmed from the inability of income investors to get enough cash flow from different types of investments. As interest rates start to rise, though, you could easily see a reversal of the multi-year flow of cash away from fixed income and into dividend-paying stocks. If that took place, dividend investors could see share prices of their favorite companies drop even if their prospects stayed stable or improved.

Crying wolf?Some investors, though, don't see the same danger signs among dividend stocks. It's true that many of these heightened valuations have persisted for several years, and it's hard to conclude from their performance in the interim that dividend stocks are an endangered species.

Nevertheless, one thing that the stock market has demonstrated time and time again is that over a long enough period, valuations do matter -- and they matter not only for the market as a whole but for individual stocks in particular as well. At some point, dividend stocks won't be able to live up to the increasingly high expectations that investors have of them. When that happens, the resulting loss of confidence among dividend investors could send shock waves throughout the entire stock market.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola, Keurig Green Mountain, McDonald's, Monster Beverage, and Procter & Gamble. The Motley Fool owns shares of Monster Beverage and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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