Untangling Dividend Stocks

Finding strong income in equities is getting trickier. Here are the top ideas from five of the best fund managers in the business.

UP UNTIL A FEW MONTHS AGO, dividend investing seemed a bit like a child’s first soccer game: Every player was a star, the spectators were happy and supportive, and the whole team got a participation sticker.

But as every parent knows, the mood starts to change after that forgiving period. The competition gets stiffer, the observers a lot more critical, and the system rewards only those rare talents who can deliver in important moments.

These days it’s feeling more like the Olympics if you’re an investor seeking income. That’s because the contest to find winning dividend payers is intense, raising the degree of difficulty to its highest level in recent memory. Stock valuations in the category are lofty after years of outperforming the broader market. The forward price/earnings ratio of the top 25% of S&P 500 stocks by dividend yield is 17, vs. a 36-year average of 12, according to Ned Davis Research. Indeed, stocks of all varieties are suffering a case of altitude sickness these days: P/E ratios are in the 97th percentile relative to levels over multiple decades.

Meanwhile, actual dividends, as piddling as they have been since the 1990s, aren’t likely to soar. The average payout ratio—the percentage of profits that companies hand to shareholders as dividends—has risen to 40%, well above where it has been over the past 10 years (except for during the financial crisis and recession, when earnings plummeted, making the ratio spike upward). Dividend increases are shrinking, and the number of decreases is accelerating.

Then there’s the monster that rarely seems to leave the closet:

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