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

Chris Hondros/2008 Getty Images

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%.

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.

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"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.

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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."

Schlesigner and several other fund managers have scanned their portfolios to come up with large-cap dividend-paying stock picks with lots of value. Read on to see which stocks they think are the best bets for 2011.

Dan Neiman, manager of the Neiman Large Cap Value Fund, has his fund's assets exclusively in large-cap dividend-paying stocks.

"We look for companies that have low debt, are cutting costs, seeing growth in revenue and earnings, and buying back shares," Neiman says. "When we look at all that, we come up with a basket of stocks and then look at only dividend payers. We pride ourselves on the conservative, stable approach to buying shares for our investors."

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Neiman uses a football analogy to describe the role stocks play in a fund or portfolio. For instance, not all stocks are the quarterback of the portfolio. He offers up one stock as a "nosetackle," which doesn't get a lot of attention but plays a critical role on the team.

Altria Group Inc.

Dividend Yield: 6%

Neiman's Take: "This is the highest-yielding stock in our fund. We see the tobacco industry being resilient and resistant to the economic downturn. There is a declining number of smokers in the U.S., but the company continues to increase the price of their products. There are new products coming out. We also see this as one of the better performers in a downturn as a defensive play, but with the rate of return from just holding the stock, it's a good solid stock to have in your portfolio. When there isn't a robust economy out there, this is one to hold."

Neiman says the fund also has positions in Altria spinoffs Philip Morris International and Kraft Foods.

Neiman also has a dividend stock recommendation that represents the largest position in the Neiman Large Cap Value Fund.

Chevron Corp.

Dividend Yield: 3.2%

Neiman's Take: "It's the largest holding in our fund and it's performed the best. It has increased its share price considerably over the past few years as we've bought it. It is still relatively undervalued with a P/E of 10. It has a solid dividend yield. It's probably the highest dividend yield of all the major oil companies at 3.2%. They've shown increasing dividends over the course of time. But when you look at the fundamentals and the higher yield, we think there's room for the price to run up."

Philip Tasho, co-founder and chief investment officer of TAMRO Capital Partners, an Alexandria, Va.-based firm with $1.4-billion (U.S.) in assets, acknowledges that large-cap stocks haven't been a winning bet over the past decade. "If you invested in large-cap domestic stocks, be it the Dow or S&P 500, you haven't made any money," Tasho says.

So what makes this a better opportunity? "Valuation. It's not a catalyst but it's a precursor to why people would buy this asset class. The financial quality of a lot of these companies is very attractive. There's fundamental strength when you look at the balance sheet, even if there's not robust top-line revenue growth."

A bank stock rates high on Tasho's list of recommendations for his clients, even if the dividend yield isn't outsized yet.

J.P. Morgan Chase & Co.

Dividend Yield: 0.5%

Tasho's Take: "That's a great company that could very well raise its dividend. From our perspective, it didn't get into the issues that so many other financial institutions did. Their yield is only 50 basis points, but if the Federal Reserve gives a nod and acknowledges that the environment for major banks is positive, you should see dividend growth."

Tasho also sees opportunity in a beaten down health-care name that pays a hearty dividend.

Johnson & Johnson

Dividend Yield: 3.5%

Tasho's Take: "This is a higher-yielding stock, with a yield of nearly 3.5%. It's very stable and it has excess cash flow. Historically, it's executed extremely well. It hasn't done terribly well this year and it's depressed in valuation. The reason why we like Johnson & Johnson is the diversified portfolio of businesses. We think they're well-positioned for the long run. They generate free cash flow relative to their [capital expenditure]needs. We see them growing it rather robustly and it puts them in a position where we think in the future they'll continue to grow their dividend."

Eric Marshall, manager of the Hodges Equity Income Fund and the Hodges Blue Chip 25 Index, says there's a lot of great opportunities in equity income.

"We wouldn't be surprised to see an emphasis on quality in the next leg of the recovery. That doesn't mean all large cap, but more stable and predictable ones," Marshall says. "If you look at the last 80 years, about 40% of the return of the S&P 500 came from dividends and the compounding of those dividends. Even though it's not very exciting to talk about blue chip stocks with 3% or 4% dividend yields, we think it's a very important component of return and investors should consider."

Marshall says bigger large-cap companies represent some of the best relative values in the market, including

Exxon Mobil Corp.

Dividend Yield: 2.4%

Marshall's Take: "This company hasn't done a whole lot for the last decade, yet you get a 2.5% dividend yield. That stock is up from where it was a decade ago, but relative to what has happened with energy, it has been a laggard. The company trades at 11 times 2011 earnings. It has an absolutely stellar balance sheet."

Marshall also looks to another company with international reach and attractive yield.

Kimberly-Clark Corp.

Dividend Yield: 4.2%

Marshall's Take: "This is a business that is somewhat recessionary proof. It's a defensive industry, even though they're affected by things like energy and other costs. There have been worries about raw materials inflation, but we think this is a company that is very well positioned over the long run to benefit from an emerging middle class. They're a mini Procter & Gamble, and you get a 4% yield. If the stock was to experience a modest 6% increase on top of that 4% yield, you'd get a very nice return without a tremendous amount of downside risk given the fact that you're paying 12 times their 2011 earnings."

Mitch Schlesinger, chief investment officer at FBB Capital, a Bethesda, Md.-based firm with more than $450-million in assets and an income bias in its portfolios, says he classifies the economic recovery as "slow and low."

"It's not going to be nearly as robust as some people are anticipating," Schlesinger says. "We're going to get a lot of volatility. A lot of data points will conflict. But there will be an underlying trend of recovery at a fairly moderate pace. Within that context, we think dividend paying stocks should provide a little more stability for a diversified portfolio. Plus, they'll potentially generate higher returns through the income side."

Schlesinger's first stock pick looks overseas to opportunity in international markets.

Philip Morris International

Dividend Yield: 4.3%

Schlesinger's Take: "We're seeing a little more growth through Philip Morris International, especially as they expand from established European locations to emerging markets, where there is less regulatory pressure on the tobacco market. We actually own both Philip Morris and Altria in our portfolio, but I like the international side."

Also in the consumer space, Schlesinger likes a stock that is yielding nearly 3%.

PepsiCo Inc.

Dividend Yield: 2.9%

Schlesinger's Take : "It's not quite as a robust dividend as Philip Morris, but it's another really strong international growth story, given the Frito-Lay snack brands making inroads in China and underdeveloped markets. The dividend isn't great, but it's 50% higher than the S&P 500's dividend. It's better than average, certainly."

Schlesinger also notes several other dividend-paying stocks that his firm finds attractive, including Verizon Communications and Pfizer Inc. .

-- Written by Robert Holmes in Boston.

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