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Is Vanguard Dividend Growth's Closing a Sign?

Some wonder whether the popular fund's closure last month may say something about dividend stocks today.

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The closing of the $31 billion Gold-rated  Vanguard Dividend Growth (VDIGX) on July 28 surprised many investors.

The official statement from Vanguard CEO Bill McNabb outlined that Vanguard is "taking steps to slow strong cash flows to help ensure that the advisor's ability to produce competitive long-term results for investors is not compromised." In other words, the fund's closure is best explained as a precautionary step to protect the fund's ability to continue to build on its strong record.

Yet, the closure has led some investors to ask: Does the fund's closing have anything to do with the state of the dividend stock market today? Are these stocks mispriced and poised to fall? Is dividend growth over? These are valid questions, considering U.S. investors have enjoyed years of strong dividend growth, and many retirees rely on dividend stocks for income.

Are Dividend Stocks Overpriced?
Morningstar analyst Alex Bryan says some dividend paying stocks, like utilities and REITs, are currently trading at high price multiples relative to their historical norm.

According to Morningstar's Market Fair Value graph, as of this writing the average real-estate stock in Morningstar's coverage area was trading at a 1.03 price/fair value ratio, meaning that the sector is about 3% overvalued. Real estate stocks hit a 52-week low price/fair value of 0.86 on Jan. 26 and a 52-week high of 1.06 on Aug. 9.

Similarly, utilities were trading at 1.09 as of this writing, meaning that the average utilities stock in Morningstar's coverage area is about 9% overvalued. The sector hit a 52-week low price/fair value of 0.93 on Sept. 4, 2015, and a 52-week high of 1.12 on Aug. 1.

Valuations on dividend-paying stocks form other sectors, however, don't look too extreme yet.

"As of Aug. 3,  Vanguard High Dividend Yield ETF (VYM) was trading at a price/fair value multiple of 1.02, while the corresponding figure for  Vanguard Dividend Appreciation ETF (VIG) was 1.04,” says Bryan.

Moreover, dividend-growth stocks, as measured by the NASDAQ U.S. Dividend Achievers Select Index, currently trade at a fairly modest premium relative to the S&P 500 (trailing 12-month P/E of 23.5 versus 20 for the S&P 500, as of July 2016), says Morningstar analyst Alec Lucas.

In fact, many dividend-paying stocks are undervalued according to Morningstar's price/fair value metric. Some examples include:

 United Technologies (UTX) focuses on commercial aerospace, defense, and building industries and is trading in 4-star range as of this writing. 

"We continue to believe that United Technologies' shares offer upside, as near-term volatility in the global macroeconomic environment often seems to steal focus from United Technologies’ favorable longer-term prospects," says equity analyst Barbara Noverini in her latest Analyst Report.

Four-star  VF Corp (VFC) owns a large portfolio of leading lifestyle brands such as The North Face, Timberland, and Vans. In her latest  Stock Analyst Note, senior equity analyst Bridget Weishaar states, "For investors who can weather likely near-term volatility given cyclical brick and mortar traffic headwinds and retailer inventory caution, we continue to believe that VF Corp has an attractive margin of safety for long-term holders."

Lastly, high-end hotel and casino operator  Wynn Resorts (WYNN) is also trading in 4-star range

"Wynn is well positioned for Macau's long-term growth opportunity," notes senior equity analyst Dan Wasoliek in his latest Analyst Report. "Wynn is synonymous with high quality, and its Macau property is the only resort in the world with seven Forbes five-star awards."

Is Dividend Growth Over?
Josh Peters, editor of Morningstar DividendInvestor, argued in a recent article that the golden era of dividend growth is over.

Peters traces the golden era to 2003 when  Microsoft (MSFT) declared its first cash dividend. Then, the federal government dropped the tax rate on dividend income to make it more equal to capital gains, ending the latter's long tax advantage. In 32 of the 49 quarters between the first quarter of 2003 and the first quarter of 2015, the year-over-year growth rate for dividends per share for the S&P 500 has been at least 10%.

Peters notes that in the first quarter of 2016, S&P 500 dividends per share rose just 4.6%, the slowest advance in almost six years, and fingers can be pointed at the energy sector. For example,  Kinder Morgan (KMI) cut investor dividends by $3.19 billion--or 74%--this year. This single cut resulted in nearly a full percentage point of drag on dividend growth for the S&P 500.  ConocoPhillips (COP) also cut investor dividends by $2.4 billion, which brought dividends down from 74 cents a share to 25 cents a share.

It's difficult to find others as bold as Peters who will call this dividend-growth slowdown the end of an era. However, many global markets are experiencing similar slowdowns. In the U.K., dividends fell 3.3% year-on-year, the weakest performance among developed countries, according to the Henderson Global Dividend Index; whereas, in Europe the dividend growth rate has slowed and is sitting at 4.1% over the same period. Suffice to say that dividend growth may not be entirely over, but investors probably shouldn't expect to see the same robust growth they've seen during the past 20 years.

What is today's dividend-stock investor to do? Here are a few tips.

Don't Blindly Buy the Highest Yielding Stocks 
Some higher-yielding stocks may present considerable risk. If dividend yields are high, it's often because companies are paying out a large share of earnings as dividends; that equates to a greater risk of cutting dividends if earnings fall.

Bryan cites ConocoPhillips as an example. The stock offered a dividend yield in excess of 6% at the end of 2015, versus an average dividend yield of about 2% on on the Dow Jones U.S. Broad Stock Market Index. The company slashed its dividend in February 2016 due to low oil and gas prices.

Don't Forget About Total Return
"Dividends are only one component--and if they are your only focus you may not get the best total return," says Bryan. Total returns includes: dividends, interest, and capital gains.

Understand Your Dividend Portfolio’s Overall Bias
If you're investing exclusively in dividend-paying stocks or funds, you may find that you have a portfolio skewing toward one or two sectors or styles. 

"Stocks that pay dividends tend to be more mature companies, so you can get a value tilt," says Bryan. Moreover, the real estate, utilities, and financial services sectors generally pay higher dividends than other sectors. What could that mean for your portfolio? Sector bias.

Remain Broadly Diversified
Whether you're a retiree who likes dividends because they meet cash-flow needs or possibly a younger person who likes the relative stability that some dividend-paying stocks can afford, the advice from experts remains the same: The best way to protect yourself from market fluctuations is to remain broadly diversified.

Ashley Redmond is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com. 

Ashley Redmond does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.