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(Chris Hondros/2008 Getty Images)
(Chris Hondros/2008 Getty Images)

TheStreet.com

Best U.S. dividend stocks to play defense in 2011 Add to ...

Dividend-paying companies such as Chevron and Altria are being thrown to the wayside, but they could be the best place to be once the exuberance over small- and mid-cap stocks dies down in 2011.

Dividend stocks provide investors with steady income but it comes at the expense of big gains. Small- and mid-cap stocks are riskier but that's justifiable as economic growth accelerates. Such was the case this year, as the Russell 2000 Index has rallied more than 25 per cent while the S&P 500 is up 12%.

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Wall Street investment banks have high hopes for the S&P 500 next year. Deutsche Bank is predicting a stellar comeback for the benchmark, with a 2011 year-end price target of 1,550. That represents a 25% increase from current levels and would put the index slightly below its all-time intraday high of 1,576.09 on Oct. 11, 2007. Analysts at Goldman Sachs, JPMorgan Chase and Bank of America have similarly bullish year-end targets of 1,400 or higher.

"Stronger growth, coupled with forecasts of relatively low 10-year Treasury yields and subdued inflation pressures underpin our bullish equity outlook," Goldman Sachs analysts wrote in a research note establishing a 12-month target of 1,450 for the S&P 500.

Investors who believe the market can achieve those high returns would be smart to scoop up growth stocks, which tend to perform better as the economy flourishes. Those predictions may ultimately prove to be too optimistic, as there's only mixed evidence the economy is improving enough to restore the S&P 500 to levels not seen since the beginning of the subprime mortgage crisis.

Unemployment remains stubbornly high in the U.S. Inflation is creeping into the economies of emerging markets. European countries are struggling to manage massive debt problems that could worsen. Commodity prices, such as grains, sugar and oil, are climbing at a rapid clip. And foreclosures in the U.S. show no sign of abating.

If the U.S. continues to see reduced uncertainty in terms of how the economy is rebounding, fund managers say there will be see an acceleration in gross domestic product (GDP) growth, which could be a catalyst for large-cap domestic equities.

Money managers say individual investors are cashing out of bond funds and piling into equities. Some are forgoing dividend stocks to chase the performance of this year's high-flyers -- perhaps a year too late.

"So many people want to hear about what's really hot," says Philip Tasho, chief investment officer of TAMRO Capital Partners. "If you're talking about the average investor, you don't want to be chasing trends. Don't just buy the latest and hottest trends. Look for the most attractive value, which is definitely large-cap dividend-paying stocks."

Tasho and other money managers point out attractive characteristics of under-loved large-caps. Most notably, the price-to-earnings (P/E) ratios are low, which makes these stocks "cheap" on a valuation basis. In addition, corporate balance sheets are carrying $2-trillion (U.S.) that will likely be deployed through mergers and acquisitions, share repurchases or increased dividend payouts. While mid- and small-cap stocks offer better growth potential, they typically don't offer an outsized dividend and aren't inexpensive based on valuation.

But why, then, would large-cap stocks rally if they haven't gone anywhere in a decade? Eric Marshall, senior vice president with Hodges Capital, has a simple explanation: compression of stock multiples.

"If you look back a decade ago, the larger-cap companies traded at much higher multiples," Marshall says. "You had Wal-Mart back in the last 1990s trading at 30 times earnings. It was the darling of Wall Street because of the great growth trajectory. But we've seen the earnings finally catching up with P/E multiples. You can name several big blue-chip companies that have doubled and tripled, yet the stock prices haven't gone anywhere."

Large-cap stocks have lower risks, and Mitch Schlesinger, chief investment officer at FBB Capital, points out the most obvious. "It's the opportunity risk that if you play the markets too defensively, you risk not participating in the full, more aggressive upside," he says. "With that in mind, I don't know that dividend-paying stocks should be the entire portfolio, but it depends on someone's specific needs and risk preferences."

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