Time to Ditch Dividend Stocks?

These income generators have been attracting plenty of investors, but may be too rich for some blood.

One man handing a stack of money to another man.

Dividend-paying stocks have been a go-to for income investors frustrated with today's paltry bond yields. In fact, mutual funds featuring dividend stocks have been consistently pulling in new cash, in contrast to the investor exodus from other stock-fund categories.

[See 8 Top-Rated Income Funds.]

Investors have poured $16 billion into U.S. dividend equity mutual funds since the beginning of the year and have withdrawn $25 billion from non-dividend funds, according to EPFR Global. Over the past four months,large-cap defensive sectors typically populated with dividend-paying stocks (think utilities, healthcare, telecommunications, and consumer staples) are clobbering the broader market. Telecom is up 14 percent and utilities are up 7 percent compared to a 1.2 percent drop in the S&P 500-stock index over the same stretch.

But investors often forget the most fundamental of investing tenets: Too much of a good thing is not always so good. Turning to dividend stocks, especially at this stage, may be an overvaluation trap.

"The search for yield in equities has become so pervasive that even superlatives like 'dividend bubble' are being thrown around, warning investors that dividend stocks are insanely overvalued," writes Brenton Flynn on investing newsletter site Motley Fool.

"While it's true that there is no shortage of dangerous dividend payers out there, from a high level there is another factor—earnings growth—that's made dividend stocks look very pricey relative to non-dividend-paying peers," he wrote.

Beyond price, dividend investing requires careful study, and sometimes investors get a little sloppy. There's no guarantee that companies will keep hiking their dividends or even pay them at all. As soon as a company needs to conserve cash, perhaps because the still-vulnerable economy slumps, dividends may be the first shareholder treat to get redlined. Dividends aren't guaranteed cash flow like a bond coupon.

[See Dividend Investors' Looming Catch-22.]

Not so fast. Of course, even rich valuations can be sustained for long periods, so it may make sense for some investors to maintain their dividend holdings, especially with interest rates predicted to remain low. Timing entry points is tricky and so is deciding when dividend stocks are too frothy. By some accounts, dividend stocks aren't there yet.

"One of the things I'm looking for as an indicator that it's too crowded is when sell-side analysts and the research reports use dividend yield as an important valuation tool. I just don't see that at all, even though we are at a time where [valuation] actually is a lot more important than it ever has been before," said Don Taylor, portfolio manager for Franklin Rising Dividends Fund, in a broadcast on his company's site.

"A lot of the companies we have that might have 3 percent or 3.5 percent yields, [and] that's not how [the sell side is] valuing the companies. They are still looking at price/earnings and other traditional valuation measures," he said.

Defensive shift. Again, not all dividend stocks are created equal.

The risk to some dividend stocks is an economy that takes off with more vigor than expected. "On one hand, you've got the stocks that have been really the biggest beneficiaries of this environment—that's an AT&T, a Verizon, a Altria Group, a Southern Company. They are well-known names that have very stable earnings, very stable cash flows, an ability to fund a very generous dividend, and still provide for a dividend growth of 3 percent, 4 percent, or 5 percent a year on average over the long term," said Josh Peters, editor of Morningstar's DividendInvestor, in a broadcast on his company's site.

"If we move into a higher-interest-rate environment that correlates with a stronger economy, on the fundamental, on the earnings and dividends side, these companies really don't have anything to gain," he said.

There's no room for their growth rates to double or triple in a faster-growing economic environment because their downside was limited. "But they do have something to give up on the valuation side," said Peters.