Top dividend funds trounce S&P 500
Managers of the best-performing dividend mutual funds yield high income and superior stock performance.
By Stan Luxenberg, TheStreet
By some measures, the credit crisis led to the worst period ever for stock dividends.
In 2008 and last year, a record number of companies cut or eliminated dividends, according to Standard & Poor's. As a result, investors dumped shares of longtime dividend payers such as General Electric (GE) and Pfizer (PFE).
Despite the upheaval, some dividend funds have excelled. Investing exclusively in dividend stocks, the Frost Dividend Value Fund (FADVX) returned 7.2% annually during the past five years, surpassing 99% of its large-value peers and outpacing the S&P 500 by 6 percentage points, according to Morningstar. Other funds that finished in the top 10% of the category include the BlackRock Equity Dividend (MDDVX), Columbia Dividend Income (LBSAX) and RiverSource Dividend Opportunity (INUTX) funds.
How did the funds succeed at a time when dividend stocks were collapsing? Instead of just buying the highest-yielding stocks, the winning managers focused on rock-solid companies that had the potential to increase dividends. The approach led the funds to steer clear from troubled financials and other shaky stocks during the market downturn.
The dividend strategy has long been supported by academic research. Studies have shown that while dividend stocks outperform non-dividend payers over long periods, not all dividend stocks generate similar returns. In a 2006 study by Credit Suisse (CS), researchers divided stocks into 10 groups based on dividend yields. Stocks in the 10th decile -- the highest-yielding group -- returned more than those in the 1st decile, which paid little or no dividends. But stocks in the 8th decile recorded the greatest total returns.
The relatively weak performance of the top decile stocks is no accident, says Dick Dahlberg, manager of Columbia Dividend Income. When stock prices fall, dividend yields rise. So many high-dividend companies are battered businesses. Companies in the top 12% of the dividend payers underperformed the market, and many high-yielding stocks eventually cut their dividends. "You get the best long-term performance from stocks that have growing dividends and yield only a bit more than the market average," Dahlberg says.
Columbia Dividend emphasizes stocks with strong balance sheets and little debt. Companies in the portfolio are so healthy that most of them increased their dividends in 2009. One of Dahlberg's favorite holdings is Exxon Mobil (XOM). Year after year, the oil giant has increased its dividend, typically boosting the payout by about 8% annually. That has helped the stock beat the S&P 500 over the past three decades.
With rich profits and plenty of cash on its balance sheet, Exxon is undervalued, Dahlberg says. "People keep saying that Exxon can't find enough oil, but the company constantly grows faster than the overall industry," he says.
Another holding Dahlberg favors is IBM (IBM). Expanding its service business, the company is increasing its return on equity and generating more cash that can be used to pay dividends.
To maintain their yields, the dividend funds keep diversified portfolios, holding stocks from a variety of industries. The mix typically includes utilities with high yields and sluggish growth as well as some stocks that have lower yields and faster growth.
To stay diversified, BlackRock Equity Dividend always keeps some holdings in each major sector. But as the credit crisis unfolded, manager Robert Shearer had trouble finding banks with reliable balance sheets. To maintain a position in financials, he began buying Canadian banks, including Toronto-Dominion Bank (TD) and Bank of Nova Scotia (BNS).
The Canadian institutions have proved resilient, and BlackRock continues to hold them. "The Canadian banks have much better credit quality than what we have in the U.S.," Shearer says. "In Canada, you have to put down 20% of the purchase price before you can get mortgage insurance."
Underweighting shaky financials helped Frost Dividend compile a sterling record. As the credit crisis worsened, the fund avoided most of the financial stocks that imploded. Life insurers seemed relatively healthy, so the managers starting buying strong companies, including Aflac (AFL) and Allstate (ALL). "We bought insurers when it became clear that their balance sheets were improving," manager Brad Thompson says.
RiverSource Dividend aims to yield 50% more than the S&P 500. In addition, the fund seeks to increase its dividend at an annual rate that outpaces inflation. In 2009, RiverSource stayed on target, since many holdings raised their dividends.
Among the holdings that increased dividends last year is Enbridge (ENB), an operator of natural-gas pipelines. "Enbridge increased earnings throughout the recession, and we expect them to show a double-digit increase this year," manager Paul Stocking says.
Another holding that increased its dividend last year is Lorillard (LO), the maker of Newport cigarettes. Even in a time of declining U.S. sales, the company has proved to be a cash cow.
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