Have these dividend stocks run too far?

In the lead-up to the US Federal Reserve’s decision to continue its quantitative easing program last week, there were rumblings that hedge funds had started to downgrade high yielding Australian stocks on the expectation that demand would fall if bond yields continue to rise.

The funds were caught off guard by the shock decision by the Fed to not ‘taper’ its quantitative easing program as previously announced, however its worth considering whether high yielding stocks at home — such as the banks and Telstra (ASX: TLS) — have also run too far.

The theory is that if the Fed decides to slow the rate at which it is purchasing long-term bonds via its quantitative easing program, bond yields will increase, decreasing the attraction of high yielding stocks as investors can switch into ‘safer’ bonds. Just the prospect of tapering has already seen the US 10-year bond yield shoot from 1.61% to 2.89% in the past four months, while the Australian yield has increased from 3% to 4% over the same time frame. So, is it time to consider selling those high yielding stocks that have appreciated so nicely over the past 12-18 months?

Of Australia’s larger stocks, the following are some of the most popular and highest yielding:

Stock P/E Dividend Yield (%) 12 Month Gain (%)
Commonwealth Bank (ASX: CBA) 15.6 4.9 31.4
CFS (ASX: CFX) 15.8 6.9 7.4
Insurance Australia Group (ASX: IAG) 11.9 6.3 29.4
NAB (ASX: NAB) 14.5 5.4 34.5
Telstra (ASX: TLS) 16.2 5.7 27.4
Westpac (ASX: WBC) 15.2 5.3 30.9
Westfield Retail Trust (ASX: WRT) 15.3 6.5 0.8

Taken in isolation, it appears as though the banks and Telstra have had the largest price rises and thus are most susceptible to a fall in the share price. When investigated further, it can also be seen that the banks’ price-to-earnings (P/E) ratio of around 15 is above the long-term average of 13, and Telstra’s P/E of 16.2 is well above the historical average of 11. Property trusts CFS and Westfield Retail Trust have had smaller price gains but current P/E of around 16 is above the sector average of 13.5.

Conversely, Insurance Australia Group’s P/E of 11.9 compares well with the sector average of 19.6 even though the share price has risen strongly in the past 12 months.

Foolish takeaway

The strong share price rises of the banks and Telstra over the past 12 months have led many to ponder whether they are due to underperform in the short to medium term. Investors should consider not only the yield, but the long-term sustainability of the yield. The payout ratio of the banks, property trusts and Telstra are in line with long-term averages, while companies such as IAG have inflated theirs through sharply higher payouts which are likely unsustainable over the medium term.

When the Fed does start to taper bond purchases, high yielding stocks will likely suffer over the short term, but with grossed-up yields between 7% and 8%, this may present an opportunity to add more to a conservative investor’s portfolio.

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Motley Fool contributor Andrew Mudie does not own shares in any of the companies mentioned.

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