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What stock sectors offer the best dividends?

Ask any investor to name a sector or two that pays dividends and you're likely to get telecoms and utilities every time. These industries have traditionally been paid the most, with the average telecom offering a nearly 4.8 percent yield and utilities paying about 3.5 percent.

What many investors don't realize is that other sectors can also be a great source of income. While no industry on the S&P 500 pays as much as telecoms and utilities, they are catching up.


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Technology, for instance, was once devoid of dividend payers. In December 2003, just 22 IT stocks paid a dividend. That's jumped to about 45 in July of this year.

When it comes to annual dividend growth, financials and consumer discretionary stocks have seen the largest increase in 2014, with 17.6 percent and 19.6 percent gains, respectively, through June.

Still, most investors continue to turn to the traditional dividend sectors for income.

"The relationship between dividends and sectors is a little bit complicated," said Joseph Gerard Paul, chief investment officer for U.S. value equities at AllianceBernstein. "When people think about dividend investing, they think about those sectors that are characterized by stability and high payout ratios."

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The problem with traditional players

After the recession, people flooded into industries with high-paying companies. Telecoms and utilities were popular, but so were real estate investment trusts and consumer staple stocks, which both pay attractive yields.

While those industries helped buoy people's returns, it also pushed up valuations in those sectors to the point where many dividend-paying companies now look overvalued.

"These sectors are pretty overpriced," said Paul, adding that utilities in particular look expensive on a book-value basis.

Other sectors look pricey, too. The S&P 500 Consumer Staples Index (S5CONS) has a price-to-earnings ratio of about 22 times, according to S&P Capital IQ, which is also near its 10-year high. In 2009 it was trading at about 15 times earnings.

For investors like Paul—he likes to own companies that are undervalued and pay an income—looking for payouts across all sectors is critical.

"You have to intersect the search for yield with valuation," he said. "That's going to give you a better chance to win in most market environments, because you can collect yields and get capital appreciation."

Stability vs. volatility

The Dividend Payout

S&P 1500
sector
Issues
Yield
% of payers
Issues paying
Yield of payers
Consumer
Discretionary
238 1.43% 59.7% 142 1.89%
Consumer
Staples
74 2.62% 78.4% 58 2.70%
Energy 94 2.14% 59.6% 56 2.26%
Financials 287 1.91% 88.9% 255 2.12%
Health Care 154 1.53% 36.4% 56 2.20%
Industrials 219 1.89% 79.0% 173 2.00%
Information
Technology
257 1.45% 37.7% 97 2.04%
Materials 102 1.90% 81.4% 83 1.97%
Telecommunication
Services
15 4.67% 66.7% 10 4.75%
Utilities 61 3.59% 100.0% 61 3.59%
S&P 1500 4501 1.92% 66.0% 991 2.27%
           
Source: S&P Dow Jones Indices

There's one main reason why some sectors pay higher dividends than others: stable earnings.

Telecom, utilities and consumer staples are considered defensive sectors that can make money in any economic environment. People aren't going to shut off their power, give up their Internet or stop buying toothpaste when times get tough.

The more predictable the revenues and earnings, the easier it is to give back some profits to shareholders, said Paul Atkinson, Aberdeen Asset Management's head of North American equities.

Sectors with less predictable earnings, such as industrials or consumer discretionary, tend to pay less because companies may need that money in a downturn. The last think anyone wants is a dividend cut.

"Companies with more volatile earnings and in more economically sensitive sectors have lower payouts," said Atkinson. "It's harder for them to plan future cash flows, and there's a greater sensitivity to economic activity that's outside of their control."

Some sectors, such as technology and materials, also pay less, because a lot of the money they do make gets reinvested in the business, he said.

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Where to look?

If you want to add some nontraditional sectors to your income portfolio, then consider financials and telecoms, said Howard Silverblatt, a senior index analyst for S&P Indices.

He pointed out that about 235 S&P 500 companies have increased their dividends this year, and financials have accounted for nearly 60 of those increases. While the sector's average yield is just 1.91 percent, these companies—which used to be better dividend payers—could start increasing their payouts as the economy improves.

At one time, the financial industry accounted for about 30 percent of the dividends that were paid by S&P 500 companies. That's down to 14.3 percent today. While Silverblatt doesn't think it'll get to where it used to be, there is still some room to grow.

Technology is also seeing good dividend growth. It only accounts for about 15 percent of all dividends paid, and it has an average 1.45 percent yield, but it accounts for the highest amount of dividends paid on a dollar basis.

In total, S&P 500 companies are paying out about $350 billion in dividends, and telecom pays $52 billion of that, said Silverblatt, adding that 45 of the 65 tech companies on the index pay a dividend.

Still, the sector can be a tricky one for dividend investors, since it's loaded with high-growth operations that pay a modest income. Atkinson prefers more mature tech names, such as Intel and Microsoft, which pays 2.67 percent and 2.6 percent yields, respectively.

"These are great dividend income–paying technology companies within a sector that is broadly difficult to get the diversity of income," he said.

While these businesses won't grow as fast as some non-dividend paying technology companies, such as Facebook or Twitter, they do have a history of upping their dividends, which in many cases can be even better for investors than unpredictable capital gains.

Where are Yields Headed?

Sector
Yield 2012
Yield 2013
Yield 2014
Consumer
Discretionary
1.60% 1.32% 1.51%
Consumer
Staples
3.01% 2.70% 2.69%
Energy 2.29% 2.20% 2.23%
Financials 1.84% 1.68% 1.77%
Health Care 2.13% 1.75% 1.65%
Industrials 2.49% 2.04% 2.08%
Information
Technology
1.75% 1.63% 1.57%
Materials 2.46% 2.11% 2.02%
Telecommunication
Services
4.85% 4.76% 4.77%
Utilities 4.38% 4.02% 3.69%
S&P 1500 2.27% 1.98% 1.99%
Source: S&P Dow Jones Indices

Intel's payout, in particular, will likely rise soon. It's raised its dividend for 10 years in a row, and Markit Group, a financial information services company, expects it to increase its payout by 15 percent sometime between July 21 and 25.

Investors should also take a close look at the energy sector, said Atkinson. Historically, this industry has been focused on growing its capital expenditures to drive production growth. Profitability wasn't a priority, he said.

That's been changing since the recession. Atkinson explained that a number of energy companies, including ConocoPhillips, which pays a 3.4 percent yield, have shown a greater focus on driving shareholder value by increasing the profitability of their drilling programs.

"That's made cash flows much more reliable," he said. "In order to see their asset valuations rise to a higher level, they need to be demonstrating a willingness to pay dividends that are attractive and growing."

Paul, who also likes large-cap technology companies, added that investors should also be looking at consumer cyclical and health care for opportunity.

Ultimately, a good portfolio should have a mix of high-yielding companies and lower-paying, more growth-oriented names, said Paul. The goal, though, is to hold a basket of stocks that pay more than the S&P 500's 2 percent yield.

"You need to take a multidimensional approach and not just focus on the highest dividend-paying sectors," he said. "Construct a portfolio with some attractive companies that pay low or no dividends and offset that by investing in businesses with higher yields. The aggregate portfolio should have a bigger yield than the market."

—By Bryan Borzykowski, special to CNBC.com

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