Why Dividends Aren't Enough

As a group, investors tend not to agree on very many things, from what steps the market will take next to whether or not certain companies are a screaming buy or just a bargain trap. But there's one thing that a majority of investors seem to agree on right now -- dividend-producing stocks are hot. With record-low bond yields and riskier segments of the stock market struggling as the global economy slows, blue chip stocks that throw off a healthy dividend are gaining wide favor.

But when so many people see opportunity in one sector of the market and you can barely read investing news sources without being hit over the head with six articles about the best dividend stocks to buy now, it makes you wonder. If so many investors are finding this corner of the market attractive, is that actually a bearish sign?

Branching out
For the record, I too think that dividend-paying stocks are an attractive prospect in our current economy. But as the market cycle for dividend stocks matures this year and the next, investors may need to be a little bit more selective with their dividend strategies. It may not be enough to simply buy passive dividend-tracking exchange-traded funds SPDR S&P Dividend ETF (NYS: SDY) or Vanguard Dividend Growth ETF (NYS: VIG) , even though these are two terrific funds and owning either of them is definitely better than not having any exposure to this sector at all.

However, once the low-hanging fruit has been picked from a sector, you need to spend more time looking for the bargains, and that's where active management comes into play. Instead of taking a passive approach and buying a random basket of stocks that pay a certain dividend yield, consider counting on the expertise of a time-tested professional to sniff out which dividend stocks still have room to run and which ones have hit their limits. You'll want a manager that doesn't wear dividend blinders, but instead takes current valuations and long-term capital appreciation potential into account along with yield. Here are two investments that measure up in these areas:

T. Rowe Price Equity Income (PRFDX)
Longtime manager Brian Rogers certainly includes the ability to generate consistent dividends among the criteria for inclusion in his portfolio, but it isn't the only factor, and not necessarily even the most important one. Rogers places equal importance on identifying stocks with meaningful potential for price appreciation and those with healthy dividend payouts. So income is part of the game here, but not the entire strategy. And while the fund sports a modest 2.1% dividend yield, the portfolio has also posted an annualized 5.6% return over the past decade and a half, compared to a 4.4% gain for the S&P 500 index. That return places Equity Income in the top quartile of all large-cap value funds in that time frame.

This well-diversified portfolio features over 100 names that are generally trading at low valuations while also offering a decent yield. What you won't find here are popular highfliers like Apple (NAS: AAPL) , which Rogers has specifically eschewed in favor of steadier and more reasonably valued names. This fund definitely isn't designed to dazzle, so investors looking for a high-octane, risk-taking portfolio should look elsewhere. But folks who want a steady, consistent performer with a focus on yield should consider this fine fund.

Vanguard Dividend Growth (VDIGX)
Another actively managed gem that focuses on dividends in the context of a well-rounded value-oriented strategy is Vanguard Dividend Growth. Manager Don Kilbride of Wellington Management looks for companies with a long history of generating healthy levels of free cash flow to fund increasing dividend payouts. The resulting portfolio is somewhat concentrated, with just 48 holdings at last glance. Defensive consumer stocks are a prime attraction here and include Johnson & Johnson (NYS: JNJ) and PepsiCo (NYS: PEP) , two companies with powerful brand names, high free cash flow, and easily defended business models.

The fund's trailing dividend yield is a reasonable 2.1%, but its real charm comes from its stellar performance track record. In the past decade, the fund has posted an annualized 7.4% return, compared to a 5.9% gain for the S&P 500 and a 5.2% showing for the average large-cap blend fund. Perhaps not surprisingly given the fund's value leanings, Dividend Growth tends to shine the brightest in downturns and more challenging markets. With low 13% turnover and a truly impressive 0.31% price point, this fund is a true winner for investors in search of an intelligent dividend investment.

If you haven't jumped on the dividend train yet, don't worry -- there's still time to profit from this trend. Just remember that you may have to do a little extra digging to find the investments best able to navigate this next phase in the market cycle.

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The article Why Dividends Aren't Enough originally appeared on Fool.com.

Amanda Kishis the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. The Motley Fool owns shares of Apple, Johnson & Johnson, and PepsiCo.Motley Fool newsletter serviceshave recommended buying shares of Apple, PepsiCo, and Johnson & Johnson, as well as creating diagonal call positions on PepsiCo and Johnson & Johnson and a bull call spread position in Apple. Tryany of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has adisclosure policy.

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