With the opportunities for safe income via bonds and treasuries at all-time lows with interest rates down close to zero in many places around the globe. Investors have been on the hunt for income from other sources.  This situation has to lead many investors into the next logical place when looking to deliver cash flow from a portfolio.  That logical place is with solid dividend paying stocks that can easily provide dividend yields over 3% with relative ease.

The main issue with a dividend-based strategy is that these dividend stocks have been getting bid up over time. Besides that, many of them are looking expensive when compared to historical pricing levels.  In fact, the premium returns provided historically (generated primarily via dividends) is not performing as well as other value factors.

Ethics and morality aside, an easy option for yield for a lot of investors has been investments in Tobacco stocks.  As of this writing, Altria Group Inc. (MO) offers a dividend yield of 3.6% and Philip Morris International (PM) has a dividend yield of 4.1%.    Those are solid returns as long as the investor is able to stomach buying stocks that may be expensive based on a declining yield.

Let’s look at dividend stocks in general in order to see how they have been bid up over time and are actually providing little premium versus the market. Then examine a few of the companies in the tobacco industry to see if they are worth an investment at this time.

Dividend Paying Stocks Not Providing a Premium to the Market

If an investor is truly only interested in yield, then buying a dividend paying stock at any price should not matter as long as the yield meets the needs of the investor.  However, there are very few investors who are able to hold on to stocks if they see huge drawdowns. Regardless of the cash dividends, they receive over and over. Contrarian Advisors put it best when they state, “…there is a strong emotional aversion to owning something which plummets in value, even if it later recovers all of its loss and then some. Most investors would rather purchase something for 30 dollars which they sell at 40 dollars, and never goes below 28 rather than buying something at 30 which they sell at 60 but only after first slumping below 15.”

That is why it is important to consider the current state of dividend paying stocks.  In case, we look at one of the largest dividend ETFs available on the market today. It is easy to see that it is not providing the premium to the market that many dividend investors are looking for.

For example, let’s look at Vanguard’s Dividend Appreciation ETF (VIG) compared to the S&P 500 (SPY) from a valuation perspective.

It is clear that dividend stocks as a whole are price similar to the market.  VIG is looking slightly more expensive when viewing it on P/B alone and although VIG has a slightly higher yield. That difference is not substantial enough to declare it as having a better valuation.  Based on this table alone, one might be just as well off by buying the SPY and not trying to focus on yield at all.

Dividend Stocks

Another view that might help us see if dividend stocks are at a higher historical valuation is looking at the dividend yield over time.  On the chart below, from Dividend.com, it is clear to see that the fund is experiencing lower dividend yields which can extrapolate as having a higher historical valuation.  When comparing to 2008, when yields were above 3% during the financial crisis and stocks is consider cheap. Today’s yield on VIG would suggest that dividend stocks are pricing higher than average.

This evidence to support that dividend stocks are experiencing higher valuations poses a risk for investors from a portfolio valuation perspective.  Investors are not seeing the higher yields that can help to offset buying at higher valuations. Which tends to protect the portfolio when the market goes down.

If buying a broad basket of dividend stocks is not providing much of a premium to the market today. What if an investor decided to only buy a concentrated basket of higher than average yielding stocks?    By doing this they will be able to lock in yields of over 3% or 4% in some cases.  The tobacco industry has been able to provide those yields.

However, even with those higher than market average yields, are these tobacco stocks any cheaper than the market right now?  Let’s take a look at what the data tells us.

Tobacco Stocks Have Higher Yields But Maybe Getting Expensive

Even if dividend stocks as a basket are not providing any additional value when compared to the S&P 500, an investor can reach for yield by buying specific stocks that are yielding, in some cases, over 4%.

Take tobacco stocks for example.  As of this writing, Altria Group Inc. (MO) has a yield of 3.6% and Philip Morris International Inc. (PM) has a yield of 4.1%.  In addition, when you look at the share price performance over time, there is no doubt that these two stocks have performed well when compared to the SPY.

Source: Morningstar

However, what should be a cause for concern is that over time. The yield has been dropping hinting that perhaps the stocks are getting over-extended and investors looking to get in now may get those higher yields today, but at the potential for lower share prices down the line.

Here are the dividend yields over time, as presented by Dividend.com.  Both Altria and Phillip Morris have seen steady drops in the dividend yield. While dividend payouts have been rising or at least staying flat.

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