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Is It Too Late to Jump on the Dividend Bandwagon?

Fund managers say dividend-paying stocks became a "crowded trade" in 2011, but they still have long-term appeal.

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By the end of the 1990s, dividends were passe. But after the turbulence of the 2008 financial crisis and its still-unfolding aftermath, dividend-paying stocks reappeared on investors' radar screens. Also, rock-bottom bond yields have pushed many income-oriented investors into stocks.

In aggregate, equity funds suffered net redemptions in 2011, but investors didn't shun those focused on dividends, which enjoyed roughly $3 billion in inflows. Dividend-oriented exchange-traded funds took in a much bigger $14.3 billion haul. Predictably, fund firms launched new offerings to take advantage of the trend, and some already-existing funds became more income-oriented.

Fund companies launched 16 dividend-focused funds in 2011, and already-established funds increasingly favored income-generating stocks. Legg Mason ClearBridge Large Cap Growth (SBLGX) said generating high income would be its primary objective. Fidelity Equity-Income II, which never fully embraced its income mandate, increased its exposure to dividend payers under new management and changed its name to Fidelity Equity Dividend Income (FEQTX) to drive the point home.

The Dividend Buzz
Morningstar fund analysts also have heard a wide range of managers, including some that heretofore haven't focused much on income, talk more about dividends recently. 

Several of those managers have said the rush into dividend payers has made those stocks more expensive, as their shrunken yields reflect. Dividend stalwart Philip Morris International (PM), for example, rose 35% in 2011, slimming its yield to 3.6%, down from 4.2% a year earlier.

AllianceBernstein (AB) chief market strategist Vadim Zlotnikov referred to the move into dividend payers as a "crowded trade" but said it's too early to bail on them. He favors non-U.S. firms, however, on valuation grounds.

The Last Yield Standing
Higher valuations may limit dividend payers' upside, but there's reason to think they still have room to run. First, bond yields are likely to remain low until at least 2014 (if the Fed gets its way), so income-producing stocks will remain one of the only places to find meaningful yield.

"In fact, we see interest rates as likely to remain low for some time amid an extended period of challenging economic growth, what PIMCO has characterized as the New Normal," said Cliff Remily, manager of PIMCO EqS Dividend (PQDAX). "Many global companies are paying dividends well above the current yield on 10-year Treasuries (as of Nov. 30, 2011), and they also provide opportunities for rising income as corporate earnings tend to grow over time." 

Dennis Stattman, manager of world-allocation BlackRock Global Allocation (MDLOX), can invest globally, but he's favored U.S. high-dividend-yielding stocks like AT&T (T) and Bristol-Myers Squibb (BMY) over lower-yielding bonds. 

Quality Control
Conceding that valuations in higher-yielding sectors like utilities and REITs look stretched, Mike Reckmeyer of Vanguard Equity-Income (VEIPX) and Vanguard Wellesley Income (VWINX) has homed in on stocks with more-average yields but the potential to grow their dividends. For example, he likes J.P. Morgan Chase (JPM), which he says is well-managed and can return to a more normal payout of 30%-40% of earnings. 

Such relatively lower-yielding but higher-quality dividend payers frequently perform better over the long term because the highest-yielding stocks often do so because they're in big trouble. "Historically, the highest-yielding 20% of stocks hasn't been the best-performing group; the next 20%, which is generally of higher quality, has that distinction," said AllianceBernstein's Zlotnikov. "This same group has also been more resilient during troubled times--such as the global financial crisis of 2007 and 2008."

Second, demographics also help, with retiring baby boomers thirsty for income. "As a yield-starved investor, do you want the 10-year Treasury or a basket of high-quality, dividend-paying stocks? I'd argue for the stocks in this case," said Osterweis (OSTFX) fund manager John Osterweis.

No Free Lunch
Third, despite record earnings, the proportion of profits that American companies pay out in dividends is at near-record lows. Last, with dividends accounting for roughly 45% of the S&P 500's return over the past 80 years, they have long-term appeal.

John Hancock's target-date fund managers invest in dividend-focused funds to offset more-volatile holdings, but the managers believe higher-yielding U.S. stocks' valuation gives them outsized upside potential, so they've bulked up their stakes in higher-yielding funds.

Don't buy dividend-paying stocks or funds that own them expecting bondlike returns, cautioned Vanguard Chief Economist Joe Davis. "If you hope to gain more income by increasing your allocation to higher-yielding bonds or dividend-paying stocks, you should be aware that your portfolio volatility will likely increase as a result," he noted in a recent blog post on the Vanguard website. "In finance jargon, such a change in strategic asset allocation is a "move to the right" along the expected-return frontier."

A version of this story originally ran as a feature in Talking Points, a series of analyses highlighting themes and insights stemming from Morningstar's conversations with fund managers. Talking Points is available to subscribers of Morningstar's Principia, Direct, and Workstation software.

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