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10 Stocks to Own During a Dividend Bubble (Update2)

(Story updated to add that Wells Fargo said today it has been warned by the SEC that it may face enforcement action over its sale of mortgage-backed securities sold in 2008, which may have played a role in the financial crisis.)

BOSTON (TheStreet) -- It may sound blasphemous, after a few years of roller-coaster stock markets and paltry bond yields, but investors seeking the best returns this year could do better avoiding the biggest dividend payers. They may consider steadily rising stocks with only OK dividends.

Case in point, the two highest dividend-paying sectors of the S&P 500 are the only decliners among the index's 10 groups this year. With the benchmark up 8.6% on the year, utilities stocks, which yield an average of 4.2%, have lost an average 2.8%. Telecommunications shares, which yield 5.9%, have fallen 0.4%.

In another example of how investor sentiment has shifted, only five of the top 25 stocks in one of last year's most popular mutual funds, Vanguard Equity-Income (VEIPX), have beaten the S&P 500 this year. The fund is up 5.5% this year after gaining 10.6% last year, when the S&P 500 eked out a 2.1% increase.

"The darlings of 2011 -- high-yielding sectors such as utilities, consumer staples and telecommunication services -- have been among the worst performers of 2012 as a strengthening domestic economy encourages investors to shift assets from defensive into more cyclical sectors," S&P Capital IQ said in a research note.

Even shares of mighty electric utility Southern Co. (SO), one of the most widely held stocks in the U.S., with a 4.29% dividend yield, are down 3% this year after gaining 26% in 2011. Health-care products giant Johnson & Johnson (JNJ), with a 3.54% dividend yield, is down 0.85% after gaining almost 10% last year.

So it's fair to say that the popularity of dividend stocks have spoiled their appeal, because their share-price appreciation last year has forced up valuations and pushed down yields.

For example, Philip Morris International ( PM) rose 35% in 2011, which trimmed its yield to 3.6% from 4.2% a year earlier.

And on top of that, more optimistic investors this year are going for stocks with better share-price prospects than the sluggish, but high-yielding, stocks they did when the market was a roaring bull back in 2007.

But Morningstar analysts say don't give up on dividend stocks just yet. "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."

And Morningstar Dividend Investor editor Josh Peters said in an interview on the firm's Web site that "dividend-paying stocks, high-payout stocks, and high-yield stocks had good absolute returns and very good relative returns last year, but they didn't move into what we think of as overvalued territory as a whole." He calls the sector "fairly valued" at this point and so not representative of what some would call a "bubble" caused by investors chasing yields and forgetting about fundamental valuations.

But another challenge facing dividend stocks is fear that their shareholders will face higher taxes. The Obama administration sent a proposal to Congress on Feb. 13 that would raise taxes on dividend income at a higher rate than now for households making more than $250,000 annually.

And that is likely to have wealthier investors thinking about reallocating their portfolios and trimming big dividend stocks if it appears it will get approved.

So, given the current environment, investors might do better if they hold stocks with more balanced returns -- that is, with more modest yields but better-than-average growth potential and share-price appreciation prospects.

Here are 10 stocks with decent dividends, good growth prospects and analyst ratings, and with a share-price appreciation better than that of the S&P 500 this year, in inverse order of return:

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