Looking for Dividends and Quality in One Package

This article was published in the January issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

Equity dividends are popular--maybe too popular. Their popularity has grown since the financial crisis because bond yields, despite rising in the past year, still remain low in absolute terms. In seeking an answer to one conundrum, however, income-seeking inves­tors may be creating another--by chasing stocks with yield, they've driven up valuations and increased risk.

Funds that invest in dividend-paying or higher-yielding stocks have been among the few kinds of equity funds to consistently attract inflows during the past five years. They've lagged the market in strong recent years like 2009 and 2013, but because they held up well in 2008 and 2011, their valuations are looking full. Areas of the market to which typical investors turn for yield, such as consumer staples and utilities, look rich. The high-teens average trailing 12-month price/earnings ratios of the Morningstar Utilities and Consumer Defensive indexes are higher than they've been since 2007 and above that of the broad stock market. The average P/E of the Morningstar Dividend Yield Focus Index was also at a multiyear high of nearly 17 at the end of January 2014.

Tight Spot
This leaves investors in a tough spot. With the 10-year Treasury at about 2.7% and other bonds offering low yields, stocks still figure to be a big part of most income-seeking investors' portfolio mix. With valua­tions looking full in income-generating stock sectors, however, they may be adding price risk by focusing on yield now.

Shunning dividend-paying stocks altogether isn't a viable option for investors who value them for their income-producing and long-term-compounding potential. Investors can mitigate some of the risk by focusing on quality, though. To help identify the dividend-focused funds with the highest-quality port­folios, I ranked and scored such funds by quality measures like average debt/capital ratio and by percentage of assets in stocks that Morningstar equity analysts think have wide moats, or sustainable competitive advantages. Here are a few that scored well and could offer dividend exposure with some downside protection should the market turn against equity yield.

Debt Averse
 Amana Income (AMANX) is a little pricey--its expense ratio is above average--but manager Nicholas Kaiser has a great long-term record here and at  Amana Growth (AMAGX). The fund invests according to Islamic principles, so it avoids companies with a lot of debt and scores well on portfolio quality.

Vanguard offers a number of solid dividend-paying options. Passive investors can choose from Vanguard Dividend Appreciation Index and Vanguard High Dividend Yield Index in open-end or exchange-traded fund format. Vanguard High Dividend Yield owns more of the richly valued utilities sector, so I'd lean toward Vanguard Dividend Appreciation because it shuns that area and tracks stocks with long histories of divi­dend increases.  Vanguard Dividend Growth (VDIGX) is one of Morningstar's favorite dividend-focused funds. It has more than 60% of its assets in wide-moat stocks, more than almost all dividend-focused funds.  Vanguard Equity Income (VEIPX) manager Michael Reckmeyer buys stocks with higher-than-market yields but won't pay up for yield or stint on growth.

Yield and Growth in Moderation
 T. Rowe Price Dividend Growth (PRDGX) is an epicure when it comes to dividends. Manager Tom Huber doesn't swear off high yield or low yield, or new or even no-dividend payers, but invests in all of them in moderation. The result is a diversified port­folio of cash-generating stocks that tends to fare well in a variety of market conditions.

These funds stand a good chance of holding up better than peers who chase yield for yield's sake. Moreover, they're good long-term holdings for investors who not only want income but also income that can grow over time.