dividend investing

Are dividend stocks in a bubble?

October 29, 2012: 5:00 AM ET

In a word, no. Despite a run-up in prices, high-yielding equities are still a good deal -- as long as you're selective.

FORTUNE -- Lowell Miller isn't your standard slick Wall Street mogul. A sandal-wearing self-described "reformed hippie" who once wrote poems for Rolling Stone, the 64-year-old runs a thriving $4 billion investment business in, of all places, the bohemian hamlet of Woodstock, N.Y. Asked the obvious question -- "Were you there in '69?" -- he confesses that he missed the legendary concert because of heavy traffic.

Lately a crowd of new investors have been finding their way to Miller's door. That's because he specializes in one of the hottest areas in the investment world today -- dividend stocks. In recent decades high-yielding "income" holdings fell out of favor, branded as the dowdy choice of retirees. But dividend stocks are enjoying a remarkable rebirth. Since the beginning of 2011, an estimated $52 billion has poured into dividend-oriented mutual funds and ETFs. The reason is basic: With interest rates at historic lows, big dividend payers offer a better yield than Treasuries, on top of healthy growth prospects.

MORE: An unlikely new way to boost your portfolio yield

The dividend revolution was overdue, and fully justified. Since 1972 dividend-paying stocks in the S&P 500 (SPX) have delivered total returns of 8.7% a year, vs. 6.9% for the entire index, according to Ned Davis Research. But the new inflows have driven up prices of dividend payers, caused yields to drop, and sparked talk of a bubble. For example, the yield on the Dow Jones Utility Average index now stands at 3.9%, vs. its 30-year average of 5.6%.

So are dividend stocks still a good investment? The answer is a resounding yes. The challenge is shifting from the traditional, overbought categories of income stocks into more overlooked choices.

Here's why a high-income strategy is just as compelling as ever, maybe more so. Today equity investors are facing a future of mediocre returns. In general the return you can expect from stocks is the sum of the dividend yield and the growth of earnings. Right now the yield on the S&P 500 is hovering around 2%, less than half its historical average. And don't count on big profit growth to fire returns, because earnings are already topping out. "Earnings are clearly at peak levels by all measures," says Chris Brightman of Research Affiliates, a firm that oversees strategies for $113 billion in investments. Two of the smartest minds in investing, Research Affiliates chief Rob Arnott and Cliff Asness, co-founder of the $50 billion hedge fund AQR Capital, predict that earnings will rise at around 4% annually, including inflation. So both Arnott and Asness forecast overall equity returns in the 6% range -- 4% profit growth plus the 2% dividend yield. But if you hold dividend payers with yields of 3% or 4%, you can add a percentage point or two per year to the 6% "market" return.

With the right picks investors can stretch their returns even further. Contrary to conventional wisdom, research shows that companies that pay large dividends actually tend to produce better profit growth than those that reinvest all their earnings. "Paying dividends forces companies to choose the most profitable investments with the limited earnings they retain," says Robert Shearer, who oversees BlackRock's $24 billion Equity Dividend fund (MDDVX).

Investors who prefer funds can choose between two major categories. The first are "mainstream" funds that focus on well-known large-cap names. A couple of excellent choices are Shearer's BlackRock Equity Dividend and the $11 billion Vanguard Dividend Growth (VDIGX). These funds typically offer a more modest yield -- the figure is 1.8% net of fees for the BlackRock offering -- but target companies that are increasing payouts. Right now Shearer is betting on cyclical stocks that could raise their dividends as the economy recovers -- a list that includes Caterpillar (CAT), DuPont (DD), and United Technologies (UTX).

MORE: Finding the beauty in ugly markets

The second category of funds are "niche" choices that are more adventurous, spicing the mix with slightly more exotic high-yield holdings. One good choice is the $117 million Touchstone Premium Yield (TPYAX), managed by Lowell Miller's firm, Miller/Howard. Touchstone, which has a yield of 3.1%, is now light on traditional income categories like REITs and utilities because of their elevated prices. Instead the fund is heavily concentrated in oil and gas, health care, and consumer products.

One of Miller's favorite holdings is NiSource (NI), a utility and pipeline company that's moving gas from the booming Marcellus Shale region in Pennsylvania. The stock has a yield of 3.8%. "It's in an extremely strong position, in part because it's so hard to build new pipelines now," says Miller. In health care Miller favors a pair of pharma companies with solid yields, Merck (MRK) (3.5%) and Eli Lilly (LLY) (3.7%), that he believes are undervalued. "The market is not giving these companies credit for their great pipelines," he says.

Miller is also enthusiastic about a sector that isn't exactly known for dividends: technology. He's been buying shares of Microchip Technology (MCHP), which makes semiconductors for products from cars to refrigerators. It boasts a 4.5% yield and a dividend that has tripled since 2005. For an old hippie who likes yield, that's pretty far out.

This story is from the November 12, 2012 issue of Fortune.

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