Why "Safe" Dividend Stocks Aren't As Safe As You Think

They say there is safety in numbers. That may be true heading into battle, but it's not necessarily true in the investment world.

Whether it's tulips, dot-com stocks or houses, popularity can push the short-term price of assets past their true long-term value. But while bubbles can build over time, price corrections can be swift.

Lots of investors get trampled in the stampede when the herd decides a popular asset is no longer worth the money. 

The latest example of a "crowded" investment comes from one a sector you might least expect. We're not in "bubble" territory yet, but buying these stocks now could be risky. 

First, let me explain how we got here...

In December 2008, the U.S. Federal Reserve lowered the Federal funds rate -- the overnight lending rate between banks -- to almost zero percent. The hope was that lower interest rates on everything from mortgages to business loans would help stimulate economic growth. But the Fed's policy also resulted in historically-low savings rates. 

This led to retirees and conservative income investors to slowly move their money out of savings accounts and U.S. Treasuries and into defensive dividend stocks in search for better yields. 

The period between 2009 and 2012 was particularly good for steady dividend-paying equities -- the "widow and orphan" stocks considered safe enough for the most risk-averse investors. Inflation was tame and the economic recovery was strong enough to deliver solid total returns from dividend stocks.

Now, the valuations of defensive dividing-paying stocks have become downright lofty. The irony, of course, is that the overcrowding in these "safe" stocks is making them less safe.

As the market plunged during the financial crisis a few years ago, many retail investors took to the sidelines. It's hard to blame them. From Oct. 9, 2007, to March 9, 2009, the S&P 500 Index dropped 56.8%. 

Even as the market rebounded, it was not a smooth ride. Every week a new worry roiled the global markets. And many retail investors continued to keep their money parked in cash or the safe haven of U.S. Treasury bonds, failing to find a worry-free entry point to get back into the market.

But as 2013 started to unfold, a new fear gripped investors on the sidelines: the fear of missing out.

As the media hyped the potential for the markets to hit all-time highs, sidelined investors eyed their meager savings account returns with disdain.

When cautious money finally started moving off the sidelines, it moved into so-called "safe" dividend-paying equities. 

In the first quarter of 2013, the S&P 500 gained an impressive 10%. The riskier cohort of stocks in the Nasdaq Composite Index managed to gain 8.2%. But neither of these market indices could hold a candle to gains in defensive stocks, primarily consumer staples and utility stocks (as you can see in the chart below).

Here are a few telling examples...

At the end of 2012, the price-to-earnings (P/E) ratio for the paper products company Kimberly Clark (NYSE: KMB) was 16.1. By the end of the first quarter of 2013, it had been pushed up to 18.7. In the same three months, the P/E of Johnson & Johnson (NYSE: JNJ) rose from 13.6 to 15.9. The P/E for pharmaceutical company Bristol-Myers Squibb (NYSE: BMY) increased to 21.9 from 16. 

Could these above-average valuations hold? It's possible. If global economic conditions worsen, the demand for defensive stocks may hold steady. On the other hand, if the market begins to correct, then the last cautious investors in may be the first fearful investors out. 

Even a small downdraft in "safe" stocks could trigger an exodus out of defensive equities back to the sidelines.

Now, I'm a fan of dividend-paying stocks, especially in challenging market environments. Every day, I scour the markets for opportunities in dividend-paying equities to add to the portfolio of my newsletter, The Daily Paycheck. But what I don't want is to overpay for dividends -- especially when other dividend-paying sectors are cheap by comparison.

While nearly every utility and shampoo company has become a high-priced investor darling, many big tech companies, for example, have been flat-out ignored. 

Companies like Microsoft (Nasdaq: MSFT), Cisco Systems (Nasdaq: CSCO) and even Apple (Nasdaq: AAPL) are growing too slowly to capture the hearts of aggressive investors. And many of those conservative income investors I just talked about -- and you may be one of them -- still perceive the tech sector to be "too risky". 

I think that's a mistake.

The relative valuations of these companies, along with their solid earnings growth projections and dividend-growth projections suggest that these stocks may actually be a safer yield play than many investors recognize. 

That's why in March, I did something I had never done in The Daily Paycheck. I bought a tech stock: Intel (Nasdaq: INTC).

In the heyday of personal computers, Intel was a tech powerhouse. But over the past few years, consumers have been gravitating toward mobile devices such as smartphones and tablets. And when it came to the semiconductors that powered mobile devices, Intel was a little late to the game. But Intel's chips have started showing up in emerging-market mobile devices, and it's a market the company expects to develop rapidly. 

The company has its share of challenges. I suspect Intel may even have to rethink its aggressive capital spending plan going forward. But it is sitting on a boatload of cash, has a solid track record of dividend growth, and -- most important -- it has a plan.

Even if Intel's rebound takes a few quarters, patient investors will be paid well to wait. At current prices, Intel has a yield of 4.3%. And investors may not have to wait long for a dividend hike -- Intel has raised its dividend for four straight years, boosting it 37.8% since May 2009.

Action to Take --> It may be a long road, but expectations for Intel's turnaround are low, which should mitigate some of the downside risk. And any positive surprise should make this stock rejoice to the upside.

I started with a small position in Intel and plan to pick up more shares over the next few months. With the market at relative highs, I would encourage investors to stage -- or dollar cost average -- into any new position.

P.S. -- Stocks like Intel that boost their payments by 15% a year or more are just one part of my "Dividend Trifecta" strategy. Simply put, it's a three-part approach to dividend investing that multiplies the effectiveness of every dollar you invest. To learn more about this strategy, go here...