BOSTON (TheStreet) -- The dividend trade is crowded, with almost every investor on the hunt for high yields. Wells Fargo analysts, however, say companies may only now be catching on to how investors are selecting stocks based on dividends.
Dividend-paying U.S. shares have been a favorite for investors following a 20% decline in stock market indices late last year. With economic growth expected to plod along and interest rates likely to remain incredibly low, investors have been forced to look for yield and steady income in other places.
In 2012, though, the market has booked the best gains in a quarter century to start the year, led not by dividend stocks but small-cap and speculative companies. Investors, it seems, are comfortable taking on more risk as Europe continues to figure its way out of a massive debt crisis.
Wells Fargo senior analyst Gina Martin Adams took a deeper dive into dividends, which she calls this decade's winning theme. While investor appetite for dividends has never been greater, Adams notes that dividend payouts are actually near record lows. She points out that the dividend payout ratio for the S&P 500 is at 27%, well below the long-term average of 53% and is at the lowest level on record since 1871.
"Companies may be only just beginning to catch on to the fact that investors are keenly interested in dividend paying stocks, for while dividends are increasing, payout ratios are at an all-time low," Adams writes. "Dividends still have plenty of room to grow."
At 2.1%, the dividend yield for the entire S&P 500 rivals the yield of the 10-year U.S. Treasury but remains below the long-term average of 4.5%, Adams notes. While that average yield may seem low, Adams points out that dividends have actually been providing the bulk of the return to shareholders. Since 2001, the S&P 500 has a total return of 26.4%, although the price-only return is just 2.3%.
The slow economic recovery has only benefitted dividend-paying companies. Adams says that, on a rolling monthly basis for the past two years, companies that grew dividends faster than their sector average have outperformed over the following six- and 12-month periods.
"Limited secular growth prospects, given debt deleveraging, combined with demographically driven investor demands seem likely to continue to elevated dividend payer relative performance," Adams adds.
Adams notes that after a combined 140 companies slashed or cut dividends in 2008 and 2009, the recent earnings recovery has aided 256 dividend increases in 2010 and 342 dividend increases in 2011. As a result, dividend breadth is the best in at least a decade.
However, Adams says, dividend increases have paled in comparison to the acceleration in profits. She has come up with three different ways for investors to take part in the dividend delight. These opportunities are highlighted on the following pages, with some of the stock picks that fall under each category.
In the hunt for dividend yield, Wells Fargo says investors should seek out higher yields. This may seem like a no-brainer, but Adams and her team make the distinction of comparing current dividend yields up against other sources of income.
For example, Adams notes that there are currently 227 companies in the S&P 500 that offer a dividend yield that is higher than the 10-year U.S. Treasury yield. Of those, 51 offer a dividend yield higher than AA-rated corporate credit.
Adams drilled down further and found more than a dozen companies in the S&P 500 with a dividend yield that is higher than the average corporate credit yield for companies of a similar rating. Merck tops that list due to its strong credit rating of Aa3. According to Moody's, corporate credit rated Aa3 has an average bond yield of 4%, below the 4.3% yield on Merck shares currently.
Moving down the list, A2- and A3-rated corporate bonds have an average yield of 4.4%, which is below the dividend yields of AT&T , Eli Lilly , Pitney Bowes , Avon Products and Verizon , among others.
Corporate debt rated Baa3, Ba1 and Ba2 have average yields of 5.9%, a yield outpaced by dividend-paying stocks like CenturyLink , Frontier Communications , Windstream and Wynn Resorts .
However, Adams doesn't make specific mention about the durability of a dividend payment for some of the high-yielders. My colleague Lindsey Bell recently noted that while Frontier Communications has the highest yield in the S&P 500 at 18%, the company's payout ratio exceeds 100%.
Wells Fargo says that investors concerned about the growth and earnings outlook may be best served to stick with the 51 current Dividend Aristocrats.
Dividend aristocrats are defined by Standard & Poor's as large-cap companies in the S&P 500 that have increased dividends every year for at least 25 straight years. Investing in only the aristocrats has been a profitable strategy, with the group returning 5.3% last year, compared to a flat return on the broader index.
Earlier this year, TheStreet offered up a list of 10 best Dividend Aristocrat stocks for 2012, but Adams and Wells Fargo break down the entire list of 51 stocks to point out every opportunity.
For example, consumer staples as a group is little changed this year even though 13 consumer staples names make the Aristocrat list, including Clorox , PepsiCo , Coke , Wal-Mart and Procter & Gamble , among others.
The next largest group of Dividend Aristocrat stocks is consumer discretionary. Inclusions on the list include McDonald's , Target , Lowe's and VF Corp. .
Investors also have plenty to choose from in the financials, health care, industrials and materials sectors. However, the decision is easy when it comes to buying energy, tech, telecom and utilities, as each sector only has one stock as an Aristocrat representative. They include Exxon Mobil , ADP , AT&T and Consolidated Edison .
Find Potential Payers
Figuring out which companies may pay dividends is a daunting task for any investor. Think about Apple , which has a massive cash hoard yet does not reward its shareholders with a dividend.
Still, Wells Fargo says as third opportunity for investors on the hunt for yield emerges with lower-than-average payout ratios and high free cash flow growth. The case is made stronger by the massive amount of cash on balance sheets (around $2 trillion) and a slowing but stable growth environment.
Adams says that this combination points to three sectors of the market, all of which are rated "overweight" by Wells Fargo's equity strategy team. They are consumer discretionary, technology and health care, all of which have below average but increasing payout ratios.
Adams notes that both consumer discretionary and technology companies have recorded among the fastest growth in free cash flow among sector over the last three years. Meanwhile, both health care and technology have the largest amount of cash sitting on balance sheets, Adams notes.
It hasn't been easy for health care investors this year. After ending 2011 as one of the best performing of the S&P 500's 10 sectors, health care is up only 3% this year, well below the rise of the overall market. Technology and consumer discretionary, meanwhile, have outperformed the broader market this year after lagging last year.
So how to the other sectors measure up for Wells Fargo? Industrials, consumer staples and utilities are rated "marketweight," while energy, materials, financials and telecom are rated "underweight."
-- Written by Robert Holmes in Boston.