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The 3% club is getting crowded: Dividend investors beware

As businesses, Ford Motor Corp. (F), Intel Corp. (INTC) and Pepsico (PEP) are about as similar as pickup trucks, memory chips and Funyuns. But in the stock market, these disparate companies are treated as nearly interchangeable  like savings accounts at different banks  based solely on how much cash one share of their stock kicks off in a year. They are just a few of the many motley members of the 3% Club.

There is now an extraordinary crowding of big U.S. stocks around the 3% dividend yield level, a threshold that seems to exert a gravitational pull as investors bereft of easy sources of income bid up equities until they yield just a bit more than the 10-year Treasury note. (A stock's yield, calculated as the annual dividend payment divided by price, falls as shares climb.)

But too many investors may implicitly be betting that these bond-like stocks will act like stocks in a low-rate bull market, and like bonds in an equity downturn. It won’t likely work out that way. If the stock market remains strong, these are unlikely to be the areas that continue to thrive. If it hits the skids, such stocks will not offer much of a buffer.

All over the map

Of the 422 stocks in the Standard & Poor’s 500 that pay any dividend at all, 58 of them now have yields within a narrow band between 3.3% and 2.7%. This roster spans virtually all industry sectors, with the expected over-representation of consumer-staples names but plenty of energy, real estate investment trust, industrial and healthcare entries as well.

Widened out a bit, almost a quarter of dividend-paying stocks in the index yield between 3.5% and 2.5%, including more than half of the members of the Dow Jones Industrial Average. Looking at a handful of stocks yielding almost exactly 3% shows how disparate their business trends and other valuation measures look.

Ford has a 2014 price-to-earnings multiple of 13, and profits are projected to fall 18% this year. Pepsico trades at a 19.5 P/E and earnings are growing limply at 3.9%. Williams Cos. (WMB) has a 51 P/E and profits are soaring by more than 35%. Kohl’s Corp. (KSS), the growth-challenged retailer, is also there, at a 12.4-times multiple and forecast growth of 5%.

They are fundamentally all over the map. No analyst would cover all of them. Few portfolio managers would be attracted to them all. Of course, the folks who follow these companies or own them are closely attuned to the specific business dynamics. But yield-first investors appear to be regarding them as about the same, and the market as a whole seems to be pricing them into a particular yield zone.

One of the most popular vehicles for capturing yield from the stock market, the iShares Select Dividend exchange-traded fund (DVY), yields 2.96%, reflecting the clustering around that 3% level. This fund is among the largest market-segment ETFs around, with $14.1 billion in assets. Together with similar funds Vanguard Dividend Appreciation (VIG), SPDR S&P Dividend (SDY) and Vanguard High Dividend Yield (VYM), more than $60 billion in assets are loaded into the top equity-yield ETFs, more than is sitting in the popular Nasdaq proxy PowerShares QQQ (QQQ).

The binge on equity yield

The collective binge on equity yield is entirely understandable. Income from “safe” bonds has been compressed by zero-interest-rate policies across the developed world. This is the same reality that has squeezed the spread between high-grade corporate debt and government yields to a post-crisis low. The personal-finance industry, too, has done a fine job hammering investors on the importance of dividends in historical stock-market returns.

And a five-year bull market has made owning higher-yielding stocks seem like a triple bonus: They deliver cash in the mail every quarter, companies have been steadily increasing payouts and the broad rise in share prices has meant capital appreciation, too.

But the dangers now rest in how expensive slow-growth, dividend-centric stocks have become and the inherently riskier nature of even those “safer” stocks, which make them vulnerable if interest rates lift and priced unattractively for long-term returns even if not.

Savita Subramanian, equity strategist at Bank of America Merrill Lynch, says, “There is not a lot more money to be made playing the flat-to-down interest-rate trade.” Most notably, her quantitative work shows that the most expensive sectors of the market are those in those “stable” areas most vulnerable to higher rates.

Tobacco, personal-care products, utilities and REITs are all among the most richly priced. Rising-rate beneficiaries, in contrast, such as communications equipment, consumer- finance and autos appear inexpensive.

The investing site Magic Diligence, which uses the “Magic Formula” value-investing ideas popularized by hedge-fund pioneer Joel Greenblatt, this week offered interesting views showing that steady-seeming names such as Kraft Foods Group (KRFT) and Kellogg Co. (K) do not truly qualify as value stocks at all, in part because of their aggressive treatment of pension obligations.

Consider, too, the recent action in Philip Morris International (PM), the huge overseas cigarette company whose central appeal to investors has been its high cash yield. The company Thursday lowered 2014 profit expectations, and the stock sold off by 2.7%  or more than half the 4.2% dividend yield locked in by yesterday’s buyers of the stock. This might be an acceptable level of volatility for some income seekers, but likely not all.

The common response to such concerns is, “Where else are you going to go?” The first answer to that question is, the market doesn’t owe anyone a comfortable place “to go” to meet one’s income needs.

For those content to accept some equity risk, slightly lower-yielding, more-cyclical stocks probably offer a decent risk-reward trade. For pure income hunters who just want to harvest coupons, municipal bonds are reasonably valued on a tax-adjusted basis. And some are finding good value in preferred stocks – a sort of debt/equity hybrid often issued by banks.

The lack of obvious, cozy alternatives simply suggests the key is in knowing what you own, why you do  and what could go wrong with it.

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