Five Great Stocks Entering a Dividend Bubble

Income investors need to be careful with some of the best companies in America. A dividend bubble appears to be forming in many great stocks. Dividends have been one of the great drivers of investment decisions for the past two years, as it was the high-yielding utility sector that performed the best of the S&P 500 sectors in 2011. The good news is that many of these high-yield dividends are in companies that are very defensive and should hold up well if the market heads south. The bad news is that money managers and investors are starting to (or will have to very soon) notice that the valuations are getting stretched and that the dividend yields are getting too low in many key high-yield dividend stocks.

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There are several driving forces behind this move. Treasuries and bonds are becoming solely for those who just cannot take the volatility of traditional investing. The 10-year Treasury yield is a dismal 1.5%, and even the 30-year is yielding only about 2.6%. Getting more than 1% interest on a bank CD is becoming a challenge. Europe is threatening to pull down the American growth story in an election year. And all of this is happening at a time when the dividend taxes are currently set to increase substantially if no changes are made to the tax code before the end of 2012.

24/7 Wall St. has selected five possible dividend bubbles that are inflating right now. We have used Thomson Reuters for forward earnings estimates and analyst price targets. For a true bubble to exist, the stock performance had to be strong, the dividend yield had to be lower than in the recent past, the current year P/E ratio had to be above normal or above the market, and the consensus price target from analysts had to be less than the current share price.

Make no mistake about a dividend bubble. A dividend bubble is much “less bad” than a valuation bubble. Go look at the price implosions of technology and Internet stocks after the dot-com bubble for proof of that. Imagining that a dividend bubble would be anywhere as bad as a valuation bubble just seems ridiculous. We even think that many of these companies will be able to keep raising their dividends ahead. These are all great companies, and that strength could even allow a dividend bubble to persist or even inflate a tad further. Still, our concern is that investors are simply having to pay up too much for these great dividends and the valuations of these great companies are getting stretched.

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The five stocks we identified that seem as though they are in a dividend bubble are as follows: AT&T, Inc. (NYSE: T) and Verizon Communications Inc. (NYSE: VZ); Altria Group Inc. (NYSE: MO); Kimberly-Clark Corporation (NYSE: KMB); and Wal-Mart Stores Inc. (NYSE: WMT). Amazingly, the analysts targets are higher than the current share prices in the utility sector, and it seems that those power giants may be able to keep hiking their payouts. We also took a look at some of the peers in this analysis. Here is why we see a dividend bubble in some of these great companies in America.

A Houston-based financial advisor named Bryon Townsend of WR Anderson & Co. recently has started to selectively lighten up on some key dividend stocks for some of his clients. He even told us, “My concern with high dividend paying stocks in this market is that many investors are making the mistake of paying 10% to 15% over 12 month price targets to chase a 3% to 4% dividend yield.”

Phones as a utility … AT&T, Inc. (NYSE: T) and Verizon Communications Inc. (NYSE: VZ) have both risen well above our fair value targets, and frankly they are above Wall St. fair value estimates. Verizon trades at $44.75 and now has a 4.5% dividend yield. The consensus analyst target is down at $41.65, and shares trade at nearly 18-times expected 2012 earnings estimates with about 16% earnings growth expected. AT&T trades at $35.55 and it still has roughly a 5% dividend yield, but the consensus price target is down at $34.52. AT&T trades at about 15-times expected 2012 earnings estimates with only 8% earnings growth expected.

What is up with smoking in America? Altria Group Inc. (NYSE: MO) is the domestic-only play for cigarette and tobacco with a $72 billion market value. At $35.43, this stock has continued to rise above our old $30 to $32 target and shares hit a new high on Tuesday, up at $35.62. The dividend yield is now “only” 4.7% due to its price appreciation and the consensus analyst target is $33.36. Altria now trades at 16-times 2012 earnings estimates. The Altria rival of Reynolds American Inc. (NYSE: RAI) is at $45.80 and trades above its price target from analysts of $43.40, but it yields closer to 5.2% and it trades at about 15.5-times the expected 2012 earnings estimates.

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Safety in consumer products, at a huge price … Kimberly-Clark Corporation (NYSE: KMB) is in far better fundamental shape than much larger rival in consumer products, Procter & Gamble (NYSE: PG). But there are dividend and value issues to consider in Kimberly-Clark as P&G is being pushed to consider either a break-up or other methods of unlocking some shareholder value. We have listed Kimberly-Clark as a stock to own for the next decade, but the yield is now down to just under 3.5% since it hit a new all-time high of $84.77 on Tuesday. This also now yields less than P&G, which is a relatively new comparable event. Kimberly-Clark trades at a whopping 16.5-times expected earnings in 2012 and analysts have a fair value target of $78.36 on the consumer products giant. This is either becoming a valuation bubble or a dividend bubble at Kimberly-Clark. Maybe both.

The king of retail’s chart breakout … Wal-Mart Stores Inc. (NYSE: WMT) used to pay out closer to 2.5% and higher, but its share performance now has its dividend yield closer to 2.2%. Shares hit an all-time high of $72.57 on Tuesday. What is interesting is that we telegraphed this as a likely explosive mover even back before the Mexico scandal. Still, business is business and money is money. Shares trade at almost 15-times expected earnings in 2012, and this one is being bid up as investors are betting that Walmart will again become the de facto shopping destination for more of America if the economy continues to soften. Analysts have a consensus target of $67.39, which is now more than $5.00 less than the current share price. What has egged part of this on is a long-term chart breakout, since this retail giant is back in favor after a decade of underperforming. The chart breakout may not be entirely played out yet, but investors should start demanding a slightly better yield from Walmart as the king of retail now that Target Corporation (NYSE: TGT) offers a better payout to its holders after a fresh dividend hike.

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This bubble does not have to panic many existing investors. We have already said that the prices could continue to rise, and the wild card is that investors may be willing to keep paying up for strong dividend yields if Treasury yields remain so low. Investors can consider getting defensive by purchasing put options to lock in gains on some of these. They also can start writing out of the money calls to get even more upside if the shares keep rising.

We are keeping a close eye on several big payout areas to make sure that dividend and payout bubbles are not forming. We are watching the moves in junk bonds, MLPs, utilities (water and power) and even in REITs. Having a high share price does not translate to being a bad company at all. In fact, the opposite appears to be the case and that has helped to create the dividend bubbles. Investors are looking for “safe” income anywhere they can get it. Still, that does not mean that they might not be overpaying for those dividends.

-JON C. OGG