Buy Dividend Stocks as Market 'Smells Like Speculation'

BOSTON ( TheStreet) -- Contrarians, rejoice: Last year's most beaten-down stocks are among the biggest winners this year. And investors are buying them to chase the rally.

But nothing's changed, professional investors say. U.S. large-cap stocks that pay a dividend remain as attractive as they have been over the past year.

For example, stocks like Netflix ( NFLX) and Bank of America ( BAC), brutalized last year, are among the top performers on the S&P 500 this year. Meanwhile many of 2011's strong dividend winners, such as Philip Morris ( PM) and Pfizer ( PFE), are underperforming the broader market this year.

Such an end-of-year strategy isn't unusual, as investors are happy to book profits on their highest-winning positions and put some money to work on stocks that could bounce back. That's why the dividend stocks that returned 20% to 40% in 2011 are trailing while other companies that lost up to 40% last year are enjoying double-digit gains already this year.

Brian Peery, portfolio manager at Hennessy Funds, says he's surprised the stock market has done as well as it has this year, with the S&P 500 already up about 7% in little over a month's time. But by comparison, the Russell 2000 Index, which is a broad measure of riskier small-cap stocks, is up 12%. That shows investors have a greater appetite for riskier equities, a turnaround from only a few short months ago when dividend-paying stocks were highly sought after for income and safety.

Investors haven't completely rotated out of some of these dividend names, instead choosing to put cash to work to buy some of the rebounding names. However, Peery says investors are making a mistake if they're tuning out the negative headlines -- particularly those emanating from Europe -- and are buying into the so-called "junk" stock rally rather than looking at more stable investment ideas.

"That's a recipe for disaster," Peery says. "It smells more like speculation. I wouldn't want to load up my portfolio like that. That's why we're telling people to invest for the long term."

Peery's point is that it doesn't make sense for investors to chase the rally after they fall behind it. "They chase the beta in order to close that gap," he says. "That's not a great way to invest. Why would you introduce more volatility into your portfolio? If you can stay with companies that have good growth prospects and are reasonably priced, it makes sense to be beta-agnostic."

That strategy has plenty of merit. Peery says that over the past 30 years, which includes nearly all types of markets and economic conditions, the price appreciation of the S&P 500 is close to 1,000%. When dividends are factored in, the gain is over 2,000%, he says. That shows that historically, dividends have been more than the returns of the capital appreciation. In other words, dividends are important for building wealth.

Investors heard every reason to be in dividend-paying large-cap U.S. stocks last year as the equity market dropped sharply amid debt crises both domestically and abroad. Volatility spiked during the summer, resulting in huge swings in the S&P 500 and other stock indices well into the fall. Investors quickly piled into the "safe" assets, like bonds, even if they were likely to see a negative real return because of inflation.

Dan Genter, president and chief investment officer of RNC Genter Capital Management, says 2012 is already reminding him of 2011, noting that the year started off with investors in a risk-on mindset before that eventually gave way to concerns over the economy. That's one reason he's a believer in a dividend strategy for portfolios.

"Frankly, there is no change in the fundamentals," Genter says. "When you look at the earnings momentum, earnings are positive but earnings growth is slowing. Plus, you have a 2.5% GDP growth environment. Purely looking at the U.S. without the European drama, that is not a situation where you should have this rapid shift back to volatile, high-beta securities."

There are a number of reasons for investors to remember why dividend stocks make sense right now. For one, Genter says that even after many large-cap U.S. dividend-paying stocks enjoyed a sharp rally in 2011 even as the market sputtered, many of these names were not bid up to levels where price-to-earnings ratios became too extended.

"Looking at our portfolios, many of the stocks we own still have P/E ratios of about 12.5 times," Genter says. "You have stocks that are still very reasonably priced. The 4% dividend yields on these names generated probably 50% of your return, too. I wouldn't abandon them this year. The fact of the matter is that these stocks are lagging behind but they're still participating."

Of the companies in his portfolios, Genter says Altria ( MO) and Philip Morris "are still strong," while he also remains bullish on Johnson & Johnson ( JNJ) and Novartis ( NVS) because they don't have patent cliffs. And while he took some profits in Intel ( INTC) after the stock's recent run, he still finds the tech giant attractive as an investment.

Peery, meanwhile, says that he's finding that dips in the market are representing great entry points for many U.S. stocks. For the average investor, he suggests looking at some of the Dogs of the Dow that are also large dividend-paying companies.

"These companies will be around long after you and I are gone," he says. "There are not a whole lot of risk of a Chevron ( CVX) or GE ( GE) going out of business. You've got all of these companies looking to reward shareholders. They're making so much money and there's only so many things they can do with it."

As one final word of caution to investors who may be tempted to chase the rally by jumping on riskier names, Peery says he doesn't believe much has changed in the past four months that would warrant a major shift in investing style.

"Is there any reason to believe there's a new paradigm where we're up 35% this year? It's hard for me to look at it that way. I have to take a step back and look at everything," Peery says. "There's euphoria, and I'm glad that investors think everything is rosy, but there is a lot of overhang. There are issues we will have to work through. If I'm looking a year out, great. If I'm looking to trade this market, I can't do it."

-- Written by Robert Holmes in Boston.

>To contact the writer of this article, click here: Robert Holmes.

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