Dividend Stocks Lose Favor as Investors Seek More Risk


Investors are moving away from dividend-paying stocks this year, highlighting the flight from so-called high-quality companies into those that have been beaten down the most.


So far, it's been one of the better trades in 2012.

Non-dividend-paying stocks on the Standard & Poor's 500 are up 8.3 percent, while dividend payers are down 1.3 percent and the index as a whole is up nearly 5 percent, according to data from Bespoke Investment Group.

That marks a sharp contrast from 2011, when companies paying dividends jumped 10.4 percent, easily outpacing the market as investors clamored for the yield they couldn't get from fixed income.

Part of the move is probably a natural rotation that the market sees from one year to the next.

But there also are underlying reasons why the big names are faltering — in particular unspectacular earningsthat have some investors concerned that the market's upper echelon has reached a plateau.

"You stretched the valuation for a lot of these dividend-payers. The utility companies and the larger bluechip companies that don't grow a lot received an awful lot of money," says Rob Lutts, president and chief investment officer at Cabot Money Management in Salem, Mass. "Sure they pay a dividend, but sooner or later you need to have earnings growth."

At the same time, the big price moves for top-quality helped push down dividends, making them less attractive from both a yield and growth perspective. The Dogs of the Dow, a popular strategy that employs buying the bottom-third of the bluechips to gain yield, has lagged the market significantly.

Lutts questions the growth potential for otherwise well-run companies like McDonald's and Yum Brands even though both are solid, well-run companies.

"We're seeing rotation into pure growth today," Lutts says. "They're popular trades that have gotten extended and need to rest. That's partly why the Dow is the lowest-performing of the major indexes."

The dividend-payers are a subset of a larger group lagging a rally this year that has given the S&P 500 a 4.36 percent price return and a 4.48 percent total return including dividends.

The 50 stocks that gained the most last year rose just under 1 percent in January, while the 50 worst-performing stocks have soared 11.8 percent.

Also, domestic stocks are underperforming multinationals this year, another trend reversal. And mutual funds had a banner January after badly underperforming last year, with the 50 largest funds gaining 5.6 percent so far, according to data from Birinyi Associates.

The trend even extended to fixed income, where triple-C paper gained nearly 5 percent for the month, outperforming its better-rated but still high-yield competitors, according to Citigroup.

"It was almost a perfect storm last year...People were tired of sitting in cash and getting no return, so they decided, 'Let's buy large dividend-paying companies, which are on the uptick," says Michael Bapis, managing director and partner at HighTower Advisors in Chicago. "This year, the underlying trend in earnings growth is slowing."

To be sure, while the trend seems well-embedded, there are perils.

Investors entered January less risk-averse and thus were willing to take on more cyclical names in the materials and financial sectors, which featured the best returns. Should volatility return and the risk-off tradere-emerge, that could send money back into the defensive names that have lagged.

Slow and Steady Rally?

In fact, Goldman Sachs strategists, in a bearish overall outlook that sees the S&P 500 retreating to 1250 by year's end, is recommending domestic dividend-payers and a select group of cyclical stocks.

"While we do not believe that low quality will continue to outperform, historically, when low quality has outperformed in January, it has retained leadership for the full year," Savita Subramanian, equity and quant strategist at Bank of America Merrill Lynch, said in a note that underscored the conflicting currents.

The market's message thus far has been a difficult one to decipher in a long-term sense, as inflows to mutual funds have totaled just $645 million so far against $11 billion for the same period in 2011.

At the same time, the Federal Reserve's stated intention of keeping interest rateslow for the next two years would boost the dividend argument.

But money has come off the sidelines from money market funds for the past two weeks, and equity mutual funds saw $1.17 billion in inflows last week after losing money three of the last four weeks and, in fact, every month since May 2011.

HighTower's Bapis thinks that as long as earnings stay weak and valuations are high for dividend-payers, lower quality will continue to lead.

"There's more of an appetite for risk," he says. "People were so conservative last year. Now there's an appetite for risk, so it's not as sexy to be in dividend stocks."