Fundamentally: Dividend-Paying Stocks Have Become More Expensive

In fact, the four best-performing categories of equity funds in 2011 — portfolios that specialize in utilities, health care, real estate investment trusts and consumer companies involved in food, beverages and other household products — all dabble in dividend-rich parts of the market. And all of these groups produced average gains of more than 7 percent last year, when the Standard Poor’s 500-stock index rose a mere 2 percent, according to the fund tracker Morningstar.

But almost as quickly as investors rediscovered dividend payers, they’ve started to learn that this strategy is becoming expensive.

“It does beg a little closer inspection,” said Mark D. Luschini, chief investment strategist at Janney Montgomery Scott. “Investors have plowed into these areas without much regard for what underlying securities are actually producing these yields and what their valuations are.”

Mr. Luschini noted, for instance, that because of their recent popularity, shares of many utilities and consumer-staples companies — businesses that produce basic household necessities like food and toothpaste — are now at or near their recent highs.

Utilities, which have historically traded at a significant discount to the S. P. 500, owing to the sector’s slower-than-average growth, have an average price-to-earnings ratio of 15, based on the trailing 12 months of earnings. That means the sector trades at a premium to the overall market P/E of about 13.

And as far as real estate investment trusts go, their prices are starting to become uncomfortably high, said Chris Cordaro, chief investment officer at RegentAtlantic Capital. “We’ve been in REITs for clients for more than 20 years, but we’re completely out of them right now because of their valuations,” he said.

Still, prices in income-producing sectors haven’t reached the point where strategists recommend abandoning the search for dividends. Instead, they say, investors just need to be more mindful of how they use the strategy.

Thomas H. Forester, manager of the Forester Value fund, which outperformed 56 percent of its peers last year, noted that his fund sold its shares of a giant utility, Dominion Resources, when they were trading at a P/E of above 15.

But his fund has not given up on the sector entirely. It continues to own shares of utilities with lower-than-average P/E ratios, like American Electric Power, which is trading at just 11 times last year’s earnings.

Mark R. Freeman, co-manager of the Gamco Westwood Balanced fund, which beat 65 percent of its peers in 2011, adds that investors would be wise to focus on high yielders and on companies with the potential to methodically bolster payouts over time. “This is the wrong time to reach for stocks with the absolute highest yields,” he said. “I’m a bigger fan of companies that are yielding 2 to 4 percent now but that promise earnings growth in the future and higher-quality balance sheets.”

FOCUSING on dividend growth should help create a more stable portfolio, market strategists say. After all, companies that can bolster their earnings and payouts consistently are likely to withstand an economic downturn better than their peers.

What’s more, this approach should help investors find dividend-payers in less-expensive sectors of the economy.

Henry B. Smith, chief equity investment officer at the Haverford Trust Company, an asset management firm in Radnor, Pa., said that the firm maintains two separate blue-chip dividend stock strategies. The first focuses on companies in position “to increase their dividends over time based on their above-average earnings growth,” he said, and is used in the Haverford Quality Growth Stock mutual fund. The other, available to clients though not through a retail fund, pays more attention to companies with higher current yields.

While the second approach outperformed the first in 2011, the dividend-growth portfolio has a lower average P/E ratio — around 10 times 2012 estimated earnings, versus about 11 for the high-yielding portfolio.

By focusing on dividend growth, investors will also be drawn to less-traditional income-producing sectors like technology.

Mr. Cordaro of RegentAtlantic says that one of his favorite dividend-paying stocks these days is Intel, the chip maker now paying out a market-beating 3.3 percent dividend yield. The stock is trading at a modest P/E of 10, and its earnings are expected to grow roughly 10 percent annually.

“You’ve got the same exact thing going on at Microsoft,” he said, referring to the software giant whose shares have a 2.9 percent dividend yield. Like Intel, Microsoft has earnings that are expected to grow around 10 percent annually, yet it is trading at less than 10 times last year’s earnings.

“If I told you in 1998 that these companies would turn into dividend leaders,” Mr. Cordaro said, “you’d say I was crazy.”

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

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