It's time for dividend-paying stocks

It appears investors are finally paying more attention to valuations, quality and dividends. This shift is a natural reaction to increasing geopolitical risk (for example, Ukraine, China and Vietnam) and “just OK” economic growth. Investors have made a concerted move away from previous high-flying groups such as biotech and small-cap companies, and dot-com-like tech startups. Early bulls are taking profits, migrating to a more risk-averse stance and seeking out high-quality, dividend-paying stocks. Investors should gravitate toward dividend stocks, as volatility is likely to increase. Many likely will find solace in the high-quality dividend stock space, just as they found it in the 1930s, 1970s, 2000s (especially 2008), 2011, last quarter and in April. Simply put, they will want “GE,” not “gee-whiz.”

ALL-TIME HIGHS

The stock market is still resilient and trading near all-time highs. But investors appear increasingly nervous and are paying massive premiums for a very narrow portion of the market in order to achieve (or try to sustain) returns. Valuations for nondividend-paying stocks within the S&P 500 appear exceptionally high, on par or higher than 2007 levels. According to FactSet, the average trailing P/E for nondividend stocks in the S&P 500 was 27.7 times (cap-weighted) as of May 23, while the trailing P/E for dividend-paying stocks was 16.3 times. The average trailing price-to-book value for nondividend stocks was 3.6 times, versus 2.5 times (cap-weighted) for dividend stocks. The S&P 500's trailing P/E is 17.1 times, and price-to-book is 2.6 times.

MARGINAL IMPROVEMENT

Alarmingly, the average trailing P/E for nondividend stocks within the S&P 500 was 28.1 times on Sept. 30, 2007, and the average trailing price-to-book for nondividend stocks was 3.1 times. The economy is exhibiting only marginal improvement. Many risks are prevalent worldwide, and caution seems warranted. We also are entering the summer, traditionally a more volatile time for the markets. I have previously asserted that the “risk-on” trade will eventually end in tears; valuations, fundamentals, quality and dividends will become paramount to investors sooner or later, and I've asked when that will occur. It appears that many investors believe the answer is “now” or “soon.” Thus, I recommend that investors continue to seek high-quality, dividend-growth stocks. Though this philosophy lagged in 2012 and 2013, it is outperforming this year. Avoid low-quality, nondividend names, which are likely to be a source of funds as investors take profits from one-time momentum stocks that appear increasingly tired. Most important, investors will need more income when volatility picks up. They also will want downside protection and risk-averse returns. Have realistic expectations of the broad stock market and economy, but be optimistic about opportunities over the short to intermediate term via high-quality dividends. Investors will need some degree of certainty and income when reality hits. They will likely rotate into dividends. Matt McCormick is a principal and portfolio manager at Bahl & Gaynor Investment Counsel.