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Bargain Dividend Stocks Keep Paying Off

Hersh Cohen, the manager of Legg Mason ClearBridge Equity Income , who has been investing in dividend stocks for four decades, is finding some of the biggest bargains of his career.

They include such companies as H.J. Heinz, Johnson & Johnson and Procter & Gamble.

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Adam Gault | OJO Images | Getty Images
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The stocks appear cheap because of their fat dividend yields, Cohen says. When share prices drop, dividend yields climb. And after languishing, many of Cohen's favorite stocks yield more than 3 percent. That's a relatively rich payout when 10-year Treasurys yield 3 percent and money markets offer negligible returns.

"This is the first time since the 1950s when you can get higher yields on great companies than you can get on fixed-income investments," Cohen said.

Cohen spoke at the Morningstar Investment Conference in Chicago. Other speakers who joined him in pounding the table for dividend stocks were Donald Kilbride, manager of Vanguard Dividend Growth , and Joe Matt, an analyst for American Funds.

Cohen argued that stock dividends can provide a reliable income stream. While some banks have cut their dividends recently, many companies have maintained long records for raising their payouts annually. During the past decade, S&P 500 dividends increased 5.9 percent annually. Companies that made dividend increases during the credit crisis included International Business Machines, PPG and Wal-Mart Stores.

"This was the worst financial crisis since the 1930s, and we had companies raise their dividends enormously," he says. "I can't predict where stock prices will be next year. But if you buy a package of these great companies, chances are that your income will be higher next year.

Kilbride says he aims to provide shareholders with dividend income that grows at an annual rate in the high single digits. To do that, he often favors stocks with growing earnings, such as software giant Oracle. Because of the uncertainties surrounding banks, Kilbride is avoiding most financial stocks. But he does own some high-quality insurers that suffered only limited damage in the recession. His holdings include Ace and Chubb. "Property and casualty is the most attractive area in financials," he says.

In recent years, many investors have shunned dividend stocks, figuring income-oriented investments tend to be slow growers. But dividend stocks have outperformed stocks that pay no dividends, Matt says. Over the past 20 years, the dividend payers of the S&P 500 have returned 9.6 percent annually. The S&P 500 as a whole — which includes dividend and nondividend payers — returned 7.7 percent.

Many investors have passed up dividend payers in favor of companies that use their cash to repurchase shares, Matt says. When companies buy back stock, they lower the number of shares outstanding. That increases earnings per share — and sometimes helps to boost stock prices. But S&P 500 companies with buybacks only returned 8.6 percent annually during the past two decades, lagging dividend stocks.

Part of the problem with buybacks is that companies overpay for their stock, Matt says. S&P 500 companies spent $600 billion on buybacks in 2007, a year stocks were peaking. But the companies spent only $130 billion on buybacks last year, when share prices were lower.

Company executives tend to buy back shares during periods when cash is plentiful — but that is when stock prices are high, Matt says. Instead of spending on high-priced shares, companies would produce better rewards for shareholders by boosting dividends.

"A stock might get a pop for the first six months after you announce a buyback, but you get better long-term results by paying dividends," Matt says.

Some Wall Street analysts worry that Congress is likely to raise taxes on dividends next year. That could erode dividend income and depress share prices. Cohen said the impact of the tax increases could be less than what some analysts fear. He says Automatic Data Processing and other companies are planning to raise their dividends to compensate shareholders for the extra tax burden.

"ADP has said that they are going to raise the dividend," Cohen says. "They can afford it, and they know that shareholders want the dividend income."

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Disclosure information was not available for Luxenberg or his company.

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