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Defensive dividend stocks are, as a class, overvalued [ClearOnMoney]
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Defensive dividend stocks are, as a class, overvalued

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Commentary

Defensive dividend stocks are, as a class, overvalued

7 May 2013 by Jim Fickett.

Last week there was an interesting article by Jonathan Davis, editor of the Independent Investor, in the Financial Times. In it, he points out that the stocks of large, solid, dividend-paying companies have performed very well in the last few years but, though they may very will continue to go up, valuations are now quite high.

… global businesses with strong free cash flow, balance sheets, an established competitive advantage and a consistent dividend record have become the darlings of all fugitives from the return-free, QE-squashed world of government bonds.

There is no doubt that the likes of Diageo, Unilever, Nestlé and Johnson & Johnson, to name just some of the top performers in the consumer segment of the market, have become very richly valued on conventional analytical measures. According to Edinburgh Partners, quoted in a recent Independent Investor report, relative to the world index, for example, global consumer staple stocks have recently been trading at their highest p/e ratio for more than 40 years.

Analysis by Style Research shows that the quintile of stocks with the lowest earnings volatility is also trading at a record 10 per cent premium to the rest of the world index. Defensive growth stocks press all the buttons that anxious or reluctant equity investors think they need: predictable, low risk and (not least) securely income generating. They are the nearest thing to a safe haven that is left. …

This month, Société Générale’s quality-income screen, which looks for stocks with decent yields and robust balance sheets, among a number of criteria, threw up less than half the total it was producing last summer. …

Nestlé now trades on a historic p/e of 19.9, according to Bloomberg …

Warren Buffett’s Berkshire Hathaway is reported to have unloaded shares in Johnson & Johnson, Kraft, Procter & Gamble, Intel and IBM in recent weeks. …

The really scary thing is that valuations of defensive growth stocks could still go the other way – up, rather than down. Markets driven by momentum can produce extraordinarily durable valuation anomalies. It happened in 1998-2000 (with tech stocks) and again in 2007 (with banks). In the Nifty Fifty era of the 1960s, the last time megacap growth stocks went to exceptionally high valuations, their average p/e ratio reached 42 times at its peak. The average dividend yield fell to barely 1.1 per cent.