Blue-Chip Dividend Stocks: Buy Like SVAAX

NEW YORK (TheStreet) -- While most funds have struggled lately, Federated Strategic Value Dividend (SVAAX) has soared. Federated returned 11.9% in the past year, topping 99% of large value funds and surpassing the S&P 500 by 11 percentage points, according to Morningstar. The winning streak occurred because Federated focuses on one of the market's hottest segments: blue-chip dividend stocks. The portfolio is full of such familiar names as H.J. Heinz (HNZ) and Johnson & Johnson (JNJ), rock-solid companies that have appealed to nervous investors.

Since blue chips move in and out of favor, Federated is not likely to excel every year. But the fund makes an intriguing pick because it has a track record for limiting losses during difficult times and delivering decent results in bull markets.

Portfolio manager Daniel Peris follows a disciplined strategy that he describes in a recent book, The Strategic Dividend Investor. The book makes the case for buying stocks that have yields ranging from about 3% to 8%.

"We are trying to offer our clients consistent income that will grow modestly over time," Peris says.

In his book, Peris cites research on the performance of big dividend stocks from 1969 through 2009. He divides the universe into quarters based on dividend yields. Stocks in the lowest-yielding quartile returned 9.8% annually, while shares in the top-yielding group returned 12.2%. The best results went to stocks in the second-highest quartile, which returned 12.8%. Stocks with no dividends trailed far behind, returning 8.2%.

Peris says that high-yielding stocks excel because the dividends help to cushion results in downturns, and the fat payouts contribute to strong total returns over the long term. But stocks with the very highest yields aren't necessarily the best choices. A double-digit yield can be a sign that investors are fleeing a stock because the company is on shaky ground.

Peris likes stocks that are increasing dividends regularly. According to research, stocks with fast-growing dividends tend to outdo slow growers. His favorite stocks have high dividends and fast growth. But few stocks fit the ideal description. Some stocks with high dividends tend to be slow growers, while stocks with faster growth often pay lower dividends.

To diversify his portfolio while including the best combination of growth and yield, Peris aims to hold a mix of stocks with different yields. At the high end of the spectrum are stocks that yield 6% to 8% and typically increase the dividend at an annual rate of 2% to 4%. The high-yielding holdings include many telecoms, such as AT&T ( T) and Verizon ( VZ). At the lower end are stocks that yield 3% to 5% and increase the dividend at a rate of 5% or more. Low-yielding holdings include Procter & Gamble ( PG) and Coca-Cola ( KO). By holding the diverse collection, Peris aims to maintain a portfolio that yields 5% and has a dividend growth rate of about 5%.

The fund has big stakes in consumer staples and health care. But there are no holdings at all in technology, industrials and basic materials. Many stocks in those sectors pay little or no dividends.

In some instances, the stocks do pay dividends, but the businesses are highly cyclical. Peris worries that such companies could fare poorly in recessions. "Materials and technology companies can be too cyclical and volatile to meet our needs," he says.

To ensure reliable performance, he looks for companies with strong balance sheets and long track records for raising dividends. If Peris spots a stock that seems a bit more appealing than a current holding, he won't necessarily trade. While many portfolio managers trade rapidly to take advantage of temporary price moves, the Federated manager aims to hold strong stocks for years.

Peris only owns companies that are dedicated to using much of their cash for dividends. In his book, he rails against managements that keep cash for empire building instead of paying investors. Peris especially shuns companies that spend heavily on acquisitions or buying back shares. Such strategies often backfire.

He lost interest in Pfizer ( PFE) in 2009 when the company cut its dividend to pay for an acquisition.

"Very few large acquisitions succeed," he says. "Big deals produce fees for Wall Street investment bankers, but the mergers don't result in much dividend income for Main Street investors."

Many academic researchers have argued that dividends can be crucial, accounting for 40% of all the total returns delivered by markets. But Peris takes a more extreme position, arguing that dividends account for about 90% of returns. To make the case, he cites data from economist Robert Shiller.

According to the Shiller data, stocks returned 9.8% annually from 1926 through 2010. Of the total returns, 4.2 percentage points came from dividends and 5.6 percentage points were due to share appreciation.

Seeing the numbers, some researchers argue that share appreciation is more important than dividends, and investors should focus on investing to obtain capital gains. But Peris says that dividends grew at an annual rate of 4.4%. He says that the dividend growth is the main factor contributing to share appreciation.

"If a company raises its distribution of profits, then the value of the business goes up," he says.

Because dividends are so important, investors should focus on obtaining them, Peris says. Companies that pay rich dividends tend to be disciplined businesses that deliver strong total returns.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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