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Weekend Investor

Biggest dividend-paying stocks are still the best

CHICAGO (MarketWatch) -- Among U.S. stocks nowadays, the bigger they are, the harder they work.

The market's giants have proven nimble and stable in the choppy global economy. Large-cap growth-stock mutual funds, for example, are up 12% so far this year, more than three percentage points above their small-cap growth counterparts, according to investment researcher Morningstar Inc.

Is there more upside? For investors who are selective, it sure looks that way.

"Large-cap stocks have shown a very persistent improving trend of relative strength recently, and with the public investor so paralyzed in today's investment world, we believe that it will be the large pools of money that recognize there is no better 'safe haven' than U.S. stocks," Don Hays of Hays Advisors wrote in his blog.

"And because the huge pool of money has to have trading liquidity, that also gives a huge advantage to these large-cap stocks," he said.

Of course, there can be too much of a good thing; some large-growth names look overbought.

"Big growth-stocks like Chipotle ((CMG) , Starbucks(SBUX) , Priceline (PCLN) -- these high growers are suffering high valuation in what realistically is still a lower [economic] growth environment," said Gus Zinn, co-manager of the Ivy Core Equity Fund (WCEAX) . "You have to be careful for any slip-ups," he added. "It could be news out of Europe, something out of their control, not even an issue of competition."

Zinn's fund is invested almost entirely in blue chips, including top-holdings Apple Inc. (AAPL) , MasterCard Inc. (MA) , General Electric Co. (GE) , Altria Group Inc. (MO) , and Monsanto Co. (MON) .

"The sweet spot right now is for growth companies, but not necessarily high-growth companies," Zinn said. The fund, he added, looks for shares of companies with steady top-line growth in the single-digit range and a focus on returning close to 10% of their market cap to shareholders with dividends and buybacks.

Investors shouldn't grab for the highest yield, Zinn cautioned. Instead, he advised, seek lower-priced stocks with dividend yields of around 2%-3% and the potential for that yield to grow.

"A very high yield often signifies that a company is distressed and may not actually be able to pay its dividend going forward," said Richard Turnill and Stuart Reeve, managing directors and portfolio managers at BlackRock Inc., in a commentary.

"While an above-average yield is an important component of total return," the managers added, "dividend growth -- a company's ability to consistently raise its dividends -- is even more powerful over the long term, through the compounding of growth on growth."

Some managers say investors, even income-seekers, may be overly infatuated with dividend stocks.

"We don't ignore dividend payers or take them off the watch list, but our preference is for companies that have ample opportunity to reinvest capital," said John Neff, analyst at Akre Capital Management.

Neff and team select among what he calls "all-weather businesses" that stand to profit in the best and worst of economic times." This includes discount retailers such as Dollar Tree Inc. (DLTR) , Ross Stores Inc. (ROST) and TJX Cos. (TJX) "Customers get used to value," Neff said, "If the economy improves, receipt size will go up even if traffic doesn't."

The Akre team also likes large caps with "real pricing power," including credit card-issuers MasterCard and Visa Inc. (V) whose revenue is measured in dollars transacted, and credit ratings-provider Moody's Corp. (MCO) which collects fees based on a percentage of debt issued. In this case, "there's built-in inflation protection (for investors), Neff said, "because of these firms' pricing power, their ability to raise fees."

Size matters

Size is relative, too. There's some indication that mega-caps (market cap exceeding $100 billion) -- the biggest of the big -- are underappreciated.

"We view mega-caps as the new market leadership. Mega caps represent growth, quality, yield and big bases," said the equity technical analysis team at Bank of America Merrill Lynch, in a commentary. Key sectors benefitting are consumer staples, health care (primarily pharmaceuticals), technology, consumer discretionary (primarily media) and telecommunications.

"Many of the stocks in the mega-cap space remain under-owned by institutional investors," the Merrill analysts noted. "Additionally, nearly half of the stocks in the S&P 100 have a statistically significant short position showing investors are fading their rallies. This is contrarian bullish, in our view, as investors don't believe in the rally."

Growth also requires headroom. As such, investors might expand their scope outside developed nations, where indebtedness and the negative impact from a slowdown in Chinese demand will limit upside potential. Emerging-market exposure through large, internationally diversified global businesses may be attractive to some investors, wrote BlackRock managers Reeve and Turnill.

Companies with global revenue diversification and attractive valuations, the BlackRock managers noted, include McDonald's(MCD) and United Parcel Service Inc. (UPS) . Read more: Let Buffett's 'moat' protect your portfolio.

Growth is relative, of course. Eric Schoenstein, co-portfolio manager of the Jensen Quality Growth Fund (JENSX) , said large-cap growth companies need to prove themselves over time.

The Jensen team won't consider companies that have not achieved 15% return on equity for 10 straight years. PepsiCo Inc. (PEP) Procter & Gamble Co. (PG) , Emerson Electric Co. (EMR) Nike Inc. (NKE) , and Microsoft Corp. (MSFT) fit that bill.

Said Schoenstein: "For us, that's a durable, competitive advantage."

Rachel Koning Beals is a Chicago-based freelance writer.