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:

10. Stryker ( SYK)

Company profile: Stryker, with a market value of $21 billion, makes medical devices and equipment used primarily in orthopedic procedures, such as reconstructive implants of knees and hips.

Dividend Yield: 1.55%

Investor takeaway: Its shares are up 11% this year and have a three-year average annual return of 19%. Stryker has 13 "strong buy" ratings, three "moderate buys," and nine "holds," according to a survey by TheStreet Ratings.

9. Nucor ( NUE)

Company profile: Nucor is a manufacturer of steel and steel products, with operating facilities and customers mainly located in North America.

Dividend Yield: 3.33%

Investor takeaway: Its shares are up 12% this year and 13% annually on average over the past three years. Analysts give Nucor seven "strong buy" ratings, one "moderate buy," six "holds," and one "moderate sell," according to a survey of analyst by TheStreet Ratings.

8. PPG Industries ( PPG)

Company profile: PPG makes glass, coating and optical products, ranging from polarized lenses for sunglasses and windshields for airplanes.

Dividend Yield: 2.55%

Investor takeaway: Its shares are up 12% this year and 47% on average over the past three years. PPG's shares have four "strong buy" ratings, two "moderate buys," and seven "holds," per TheStreet Ratings.

7. Wells Fargo ( WFC)

Company profile: Wells Fargo is one of the four largest banks in the U.S., with $1.3 trillion in assets at the end of 2011. The company's businesses include mortgages, community banking, wholesale banking, and wealth, brokerage, and retirement services. Wells Fargo, along with Goldman Sachs ( GS), said Wednesday that they received Wells notices from the Securities and Exchange Commission indicating that they companies may face civil enforcement actions over mortgage-backed securities that the firms sold in 2008, which may have played a role in the 2008 financial crisis.

Dividend Yield: 1.55%

Investor takeaway: Its shares are up 13% this year and have a three-year average annual return of 38%. Wells Fargo has 16 "strong buy" ratings, three "moderate buys," and three "holds," TheStreet Ratings says.

6. Allianz ( ALV)

Company profile: Allianz of Germany, Europe's biggest insurer, is a leading financial-services company that offers insurance and asset-management services.

Dividend Yield: 3.62%

Investor takeaway: Its shares are up 15% this year and have a three-year average annual return of 24%. Allianz has one "strong buy" rating, and two "holds," according to TheStreet Ratings.

5. Sigma-Aldrich ( SIAL)

Company profile: Sigma-Aldrich is a leading provider of research consumables and fine chemicals to a variety of players in the life sciences and technology industries.

Dividend Yield: 1.1%

Investor takeaway: Its shares are up 17% this year and 28% on average over the past three years. Sigma-Aldrich has seven "strong buy" ratings and seven "holds," per TheStreet Ratings.

4. VF Corp. ( VFC)

Company profile: VF manufactures and markets clothing, specializing in jeans, sportswear, outdoor apparel, and footwear. Its apparel brands include Lee, Wrangler, The North Face, and Nautica.

Dividend Yield: 1.97%

Investor takeaway: Its shares are up 17% this year and 44% over the past three years, on average. Analysts give VF Corp. 10 "strong buy" ratings, one "moderate buy," and six "holds," TheStreet Ratings says.

3. JPMorgan Chase ( JPM)

Company profile: JPMorgan is an international financial-services, institutional and investment bank with a $148 billion market value.

Dividend Yield: 2.60%

Investor takeaway: Its shares are up 18% this year and an average annual 21% over three years. Analysts give JPMorgan 17 "strong buy" ratings, four "moderate buys," and three "holds," per TheStreet Ratings.

2. Illinois Tool Works ( ITW)

Company profile: Illinois Tool Works is a manufacturer of a range of industrial products and equipment including industrial packaging, electronics, and polymers and fluids.

Dividend Yield: 2.58%

Investor takeaway: Its shares are up 20% this year and 29% over the past three years, on average. Illinois Tool Works has nine "strong buy" ratings and seven "holds," according to a survey by TheStreet Ratings.

1. Microsoft ( MSFT)

Company profile: Microsoft, with a market value of $264 billion, develops the Windows PC operating system, the Office suite of productivity software, and its other businesses include the Xbox 360 video game console, the Bing Internet search engine, business software, and software for mobile devices. Cloud computing, or the computing world's shift to Web-based applications, is the latest challenge to its operating system but it is likely to find new ventures in cloud computing to make up for that.Microsoft Wednesday launched the first test version of Windows 8, to gather consumer feedback on the new operating system. Windows 8, which isn't expected to be released commercially until late this year, is designed to give Microsoft a presence in the fast-growing tablet market.

Dividend Yield: 2.54%

Investor takeaway: Its shares are up 22% this year and have a three-year average annual return of 25%. Analysts give Microsoft 14 "buy" ratings, nine "buy/holds," 14 "holds," and one "sell," according to an S&P survey.

>>To see these stocks in action, visit the 10 Stocks to Own During a Dividend Bubble portfolio on Stockpickr.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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