Dividend Payers ... The "New" Substitute for Owning Bonds ...

Investing in bonds has long been recommended as an important part of a diversified investment approach for both individuals and institutions.

That's changing now and properly so. I expect that safe dividend paying stocks will become the "new" bonds in more investment portfolios and here's why.

It's a simple matter of comparing the interest rate levels on bonds to the cash dividend yields on stocks. Throw in the fact that dividends on 'defensive' stocks will increase over time, as will share prices, and the decision to replace bonds with dividend paying stocks becomes a no-brainer. At least that's my view.

In Stocks, Payouts Trump Potential has this to say:

"Analysts expect paper-towel, toothpaste and soap maker Procter & Gamble to churn out per-share earnings growth of about 6% this year. Google's profits will jump 18%, other analysts predict.

So which stock is hotter?

The answer: P&G, trading at 18 times projected per-share earnings and far above its five-year average of 15.4, according to data provider FactSet. In contrast, Google has a P/E ratio of 16.6, below its five-year average of 17.2.

Investors are attracted by P&G's sturdy dividend yield of 3.1%, assuring them at least a modest return on a stock known for its reliable performance. Google pays no dividend. {NOTE: For 'Gretzky' types who skate to where the puck is going to be, Google looks good to me as a "future dividend payer," too.}

Investors searching for higher yields are driving up the shares of dividend-paying companies, fueling a debate over whether these traditional haven stocks are getting dangerously expensive. Some buyers argue that dividend stocks have entered a period where demand for income will keep valuations high, perhaps for years, thanks to Federal Reserve easy-money policies that are expected to remain in place at least into 2015. Skeptics say the "this time is different" thesis will prove wrong, and that investors will discover they have overpaid.

Demand for dividend payers has led to the unusual sight of stodgy, slow-growing companies commanding higher valuations than stocks with fast-growing profit streams. That is especially unusual in a bull market . . . .

James Swanson, chief investment strategist at MFS Investment Management, which oversees about $350 billion, says he understands the appeal of dividend stocks given historically low interest rates. But he says the effect on valuations is "the biggest glaring discrepancy I see in the market."

"You have these tech companies that have double-digit earnings growth, no debt, huge cash balances and they're trading at 12 times forward earnings, while you have a utility in Ohio at 16 times earnings," he says. "If you don't think there's a recession coming, how far do you go with this game?"

Pretty far, says Donald Taylor, a portfolio manager at Franklin Templeton Investments, who argues there are powerful forces driving up long-term valuations for dividend payers.

"We could be in this world for quite some time," says Mr. Taylor, who manages the $10 billion Franklin Rising Dividends Fund. "The macro environment that has caused utilities and telecoms, as well as consumer staples, to be expensive relative to history…is not at all likely to change anytime soon.". . .

Dividends, say those bullish on the sector, are only beginning to reclaim the role they have historically played in generating profits for investors. Dividends account for more than half of total returns since 1928, according to Strategas Research Partners. During the 1930s and the first decade of this century, when the Standard & Poor's 500-stock index lost ground, dividends accounted for all the gains.

That the market's most conservative stocks now command a higher valuation than companies generating faster earnings growth is another ripple from the Fed's easy-money policies.

As the Fed has pushed down yields on U.S. government bonds, and pledged to keep rates low for years, investors have gravitated into riskier investments in search of yield. . . .

"This is not a product of equity investors buying defensive stocks and hiding out," sayid Chris Wallis, chief investment officer of Vaughan Nelson Investment Management, which manages about $8 billion in assets in Houston.

"What we have is money that had typically gone to fixed income now coming into equities," Mr. Wallis said. "They're looking for bond substitutes and it doesn't mean that the money is going to exit and go either to cyclical stocks or go to cash. I think it's going to stay where it is."

Barry Knapp, chief U.S. equity strategist for Barclays, points to Fed policy in recommending clients stick to high-dividend payers despite "richness" in these stocks' valuations. "If you're in this for a long period of time, we suggest you stick with these stocks, as long as the Fed sticks to its current policy," a scenario he says could persist for years.

Another reason dividend bulls think demand for the stocks will remain strong is that many U.S. companies, particularly in the technology and financial sectors, are deploying growing cash hoards by paying dividends for the first time, or ramping up existing payouts. And there is more to go, they argue. S&P 500 companies pay out about a third of their profits in dividends, below the long-term average of about 50%, Strategas said.

"There's definitely been a call from shareholders for capital to be returned, because people are so desperate for yield," said Emily Jones, vice president of investment strategy at Strategas.

Another rationale for higher valuations: baby boomers. As the wave of boomers heads into retirement, demand for the income generated by dividend stocks will only increase.

"The average person in the U.S. would prefer more of an income orientation, for life-cycle reasons," said Franklin Templeton's Mr. Taylor. . . .

Ms. Jones (argues) that as any eventual Fed tightening inflicts losses on bond investors, some of that money will gravitate toward dividend stocks.

"We definitely think there's more room to go in the dividend trade," she says."

Summing Up

Dividend paying stocks such as consumer staples, utilities, telecommunications and health care companies are all good substitutes for bonds and will likely continue to be for years to come. Of the four sectors, I like health care best for potential share price appreciation over the next several years.

Meanwhile, technology, industrials, energy and financial stocks look poised to be strong contributors to solid market returns over the long haul as well. All four sectors look good to me.

Materials and consumer discretionary stocks are my least favorites, although they should do OK, too.

So as long as the government knows best gang doesn't do anything too terribly wrong to ruin the outlook, things look good for equity investors in the years ahead, both with respect to current income and long term share price appreciation.

At least that's my view.

Thanks. Bob.