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Dividend Stocks Lag as Investors Load Up on Risk

Stocks in this article: TGTEVTSUMLR

BOSTON ( TheStreet Ratings) -- The Dividend Stars portfolio rose 2.85% in February on a total return basis, underperforming the benchmark S&P 500 Index over the same period by 0.53 percentage point.

Since being launched Nov. 10, the Dividend Stars portfolio has returned 9.82% versus 10.94% for the S&P 500, a lag of 112 basis points. So far in 2012, the portfolio is trailing the S&P 500 by 2.1 percentage points. (Please note: The benchmark will be changed to the Dow Jones U.S. Dividend 100 Index beginning in March.) The current portfolio offers an average dividend yield of 2.71% versus 2.0% for the S&P 500.

Since the start of 2012, investors have turned away from defensive sectors and dividend-paying stocks, and have assumed more risk. According to Merrill Lynch research, low-quality stocks (those with a C&D quality ranking) have returned 20.4% this year, while stocks with a higher-quality rating (A or A+) have returned only 5.7%.

As is often the case during periods of increased market confidence, investors are bidding up companies with greater-than-average leverage, are more volatile and cyclical in nature. The best-performing sectors in the month were technology, financials and energy (all cyclical sectors), while the best-performing factors in the month were low-price-to-book and high beta. Deeper-value names that had been left for dead are now coming back to life as optimism abounds and investors seek higher growth names with higher return potential. Translation: The risk trade is most certainly on.

It's no surprise that dividend-paying stocks have been brushed aside in favor of lower-quality, higher-beta names. Based on the aforementioned Merrill Lynch research, non-yielding stocks significantly outperformed in the month; stocks with zero yields returned 3.53% versus stocks with a yield of 3.16% or higher, which returned minus 1.49%. The trend this year is even more significant as zero yielders have returned 6.82%, while the highest-yielding stocks have returned minus 6.7%.

I'm never happy to underperform the index, but based on some of the statistics I've provided, it's quite evident that dividend stocks have fallen out of favor of late. This doesn't mean that I will change the methodology of the strategy. In fact, I'm quite pleased with the performance, given the numerous headwinds. What I do think makes sense is a change of the benchmark from the S&P 500 to the Dow Jones U.S. Dividend 100 Index (DJUSDIVT).

The Dow Jones U.S. Dividend 100 Index consists of 100 stocks that are selected based on four fundamentals-based characteristics (cash flow to total debt, return on equity, dividend yield and five-year dividend growth rate) and are subject to screens for dividend payment consistency, size and liquidity. Going forward, I will be using this index to track performance, as I believe it offers a better representation of the Dividend Stars strategy. On a total return basis, since the launch in November, the Dividend Stars portfolio has returned 9.82% versus 8.06% for the Dow Jones index. So far in 2012, the Dividend Stars portfolio has returned 5.96% versus 4.62% for the DJUSDIVT.

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Portfolio Changes:

Positions Sold in the Month: Tim Participacoes (TSU)which fell below our required efficiency threshold for return on equity. It's right on the line, and it's a tough position to sell, since the company is the leading wireless provider in Brazil, an area which still has a lot of room for growth. There were no positions added during the month.

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Highlights:

Target (MTGT) (+12.2%), the best performer in the month, announced fourth quarter profits which beat analyst expectations and announced Q1 guidance of $1.07 (fifteen cents higher than expected). While margins were affected due to intense holiday competition, the company appears to be executing almost flawlessly, even as profits are temporarily squeezed due to expansion in Canada. Most recently, the company announced February same store sales of 7%, which easily beat expectations of 5.2%. Target is obviously taking share from the likes of competitors such as Kohl's and Sears as management is dedicated to providing a better experience to its shoppers. A focus on fresh food offerings, its highly successful rewards card program, and its new smaller-format City Target stores are helping the company differentiate itself from the competition.

Eaton Vance (EV) (+9.1%) a new addition in January was our second best performer in the month. The company announced first quarter profits which beat estimates, although profits were driven primarily by investment gains. During the quarter, net outflows were $1.1 billion. The drag on outflows is due to the huge outflows (nearly $2.1 billion in the quarter) from the Eaton Vance Large Cap Value fund, which has lagged peers on a one and three year basis. Management did note that flows have turned positive and that net flows for the upcoming quarter will likely be positive. Eaton Vance does have about a 35% weighting in fixed income products, and therefore will not participate as much as other asset managers in a strong bull equity market. Yet, I like the diversification of the products and still think that Eaton Vance is a best of breed manager-one to own for an up or down market.

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Lowlights:

Miller Industries (MLR), the largest manufacturer of tow truck and vehicle recovery equipment was the month's worst performer. While there was no company specific news, I can only assume the stock was down due to the announcement of February's auto sales reaching a four year high. Last month I noted that used automobiles currently have an average age of 10.8 years old (also an all time high), so I'm not surprised to see new auto sales surging. More new cars on the road replacing used vehicles means less need for towing services. Yet, the stock looks cheap- trading at 3.5x EV/EBITA, and there are still a lot of old cars on the road.

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