Bullish on Dividends

Investors have been conditioned to think that cash payouts are a defensive maneuver, and that stocks with higher yields are safer holdings in dicey markets. And now that the top 15% tax rate on dividends has been extended for another two years, dividend-paying stocks can continue to hold bragging rights over other investments, such as Treasury securities and corporate bonds, that generate comparable interest income. But last year offered powerful evidence that dividend-paying stocks can be a sound investment even if you're optimistic about the market.

That runs counter to piles of academic studies that argue that dividends are a drag on investment returns in a rising stock market or an expanding economy. That's because companies are supposed to use their spare cash to expand, buy other businesses or do something more imaginative than return it to their shareholders. But last year's strong stock-market gains went hand in hand with $26.5 billion in dividend increases, and the same forces are still at work: slowly improving economic growth, strong corporate balance sheets with plenty of excess cash, access to still-cheap credit, and confidence that profits will stay healthy. So here are a couple of ways to combine juicy dividends with aggressive stock-market expectations.

Dogs That Bite

Start with one of the most familiar dividend-oriented strategies, the Dogs of the Dow. This maneuver involves buying shares of the ten highest-yielding companies in the Dow Jones industrial average -- called the Dogs because a high dividend yield can stem from a depressed share price -- and revisiting the list a year later to adjust accordingly. In 2010, the Dogs returned 21.0%, compared with 14.0% for the entire Dow (and 15.1% for Standard & Poor's 500-stock index). The list includes AT&T (symbol T) and Verizon (VZ), whose early-January yields of 6.0% and 5.4%, respectively, dwarf what you can get by owning their own short- or intermediate-term bonds.

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At the start of 2011, Dog lovers would have added Johnson & Johnson (JNJ) and Intel (INTC) and removed Boeing (BA) and Home Depot (HD). The portfolio would also have McDonald's (MCD), DuPont (DD), Kraft Foods (KFT), Chevron (CVX), Merck (MRK) and Pfizer (PFE). Even though the Dogs include three health stocks -- all problematic for a variety of reasons -- they should have another fine year, especially the food, phone and industrial companies. Plus, the Dogs give you an average dividend yield of 3.9%.

Other groups of stocks are capable of running with the Dogs, as well as beating the overall stock market. To screen for additional high-yielding winners, I first looked up companies that had racked up more than 50 straight years of dividend increases. I further refined my search by screening for firms that are sitting on piles of cash. This isn't the same list as Standard & Poor's "dividend aristocrats" because not all of my companies are in the S&P 500. My group -- let's call them the True Believers -- chalked up excellent total returns last year. The top ten names, ranked by the number of years of consecutive dividend increases, produced an average total return of 23.5%. They were led by Parker Hannifin (PH), up 59%; Dover (DOV), up 44%; and Genuine Parts (GPC), up 41%. Oddly enough, two of the weaker links were Procter & Gamble (PG) and 3M (MMM), which are in the Dow but don't qualify as Dogs because they don't yield enough. Nevertheless, I still think the shares of 3M and P&G will do much better in 2011 than, say, a general government-bond fund or a ladder of CDs.

I could easily slice and dice the dividend record to come up with other portfolios that should have a good year, assuming that interest rates don't spike and choke off the bull market. If you're having second thoughts about your bonds, go for solid companies that pay generous dividends.