Dividends are great. they play a huge role in total return. They are a sign that a company is well managed enough, fiscally disciplined enough, to deploy cash and give it back to shareholders. They offer a way to juice yield if you’re a retiree or an endowment at a time when getting money out of bonds is like drawing blood from a turnip.

But dividends can fall prey to faddism, too—and the last months of 2013 and the early months of 2014 were proof.

After making a major comeback in the last four years after years of being black sheep, dividend stocks suffered a new cold shower in 2013, first after the Fed made its remarks about the end of quantitative easing and later after bonds saw their yields rise. The fear of imminently rising interest rates hurt all yield-bearing securities, from bonds to real estate investment trusts … and dividend funds, too.

Thus, the names in Lipper’s equity income mutual fund space saw net outflows for the first three months of 2014, and ETFs in the space saw outflows for five consecutive months from November of last year to March 2014. According to Lipper’s stats, some $2.3 billion flowed out of both dividend mutual funds and ETFs in the first quarter.

“That was pretty significant,” says Barry Fennell, a research analyst at Lipper.“Three consecutive monthly [negative] flows hasn’t happened in four years, since 2010.

“Real estate funds had a very similar pattern where they went negative the first quarter after a long stretch of positive flows,” he adds. “Now they’ve turned positive also.”

In the second quarter of 2014, poorer performance in bonds and the volatility in the stock market have lured investors back. Usually, the conservative nature of income funds and their blue-chip names—things like Pepsi, J.P. Morgan, GE and Wells Fargo—draw people when stocks are frenetic or bonds aren’t paying off, he says.

The dividends act as an anchor on volatility, says Howard Silverblatt, senior index analyst at Standard & Poor’s.

The dividend trend should continue anyway, simply because income investors have no choice, says Silverblatt. “There are not a lot of places where dividend people can go. You can’t go to bonds, you can’t go into CDs. You can’t go into REITs, which have no tax advantage.”

Jay Wong who co-manages the Payden Equity Income Fund at Payden & Rygel, says his fund briefly saw outflows last summer after the first rate warning. “People were fearful of a rate backup,” he says.

But he says earnings and GDP growth should trump rising interest rates when investors are looking at dividend fundamentals. The thing he’s afraid of is a sharp interest rate spike over a short period, which is what he says spooked investors last summer.

Almost all of the funds in the income universe at Lipper have a higher yield than the S&P 500, says Fennell, which was about 1.88% in early June. “A lot of these funds are yielding upper 2’s to 3%,” he says.

All Shook Up
The fundamentals are the same, but the names are very different. According to Fennell, the high dividend payers are now companies like Microsoft, for instance—the largest holding in the Vanguard Dividend Growth Fund, which is the second largest fund in the category at $21.1 billion. 

In the past, tech companies were disappointing misers, says Silverblatt, but their payouts, especially among chic names like Apple, are now part of their appeal. They have in essence swapped places with the financial services companies, which have become so straight-jacketed since the 2008 crisis that their payouts to investors have shrunk.

Paul Hogan, a portfolio manager with the FAM Equity-Income Fund, a strategy that focuses on companies with steady dividend growth, says that a lot of tech names have become cash rich and thus are able to pay more dividends. So his fund now has a higher tech weighting than the typical equity income fund.

“The semiconductor companies really pay nice dividends,” Hogan says. “These are really intellectual property. They outsource manufacturing and distribution. They really just need to spend money on R&D. So that leaves a lot of cash.” He points to such fund holdings as Xilinx and Microchip Technology.

“Part of it is understanding where the company is in its life cycle,” says Eric Schoenstein, a portfolio manager who seeks high-ROE investments for Jensen Investment Management in Lake Oswego, Ore. “We’ve had companies in the past that have had a fairly sustained level of growth that are still capturing a lot of opportunity and market share, in which case they haven’t gone down the path of paying a substantial dividend share because a lot of the cash flow they are producing is going back into the company at this stage.” He cites two growth companies he likes, IT services provider Cognizant Technology Solutions and medical device manufacturer Varian Medical Systems, that don’t pay dividends because they are still using capital in their growth.

Other portfolio managers are quick to remind investors, however, that just dividends, alone, are not enough to cut it. Chasing yield is not enough to cut it. A stock has to be able to maintain its earnings power.

Michael Cuggino, the president and portfolio manager at the Permanent Portfolio Family of Funds in San Francisco, says that in his firm’s growth equity funds, including the Aggressive Growth Portfolio, he is looking for companies with three- to five-year great growth stories that are leaders in their fields. Dividends are one aspect of that. He wants names that have pricing power and can control their cost structure. He shuns industries like the auto sector and utilities, for instance, that face regulation and legacy costs for their unwieldy infrastructure. Who cares if they pay good dividends?

“GM, for example, they are trading at a market P/E of 18 and paying a dividend of 3.5%. Definitely supportable by current earnings, but as you know, the auto industry earnings can be cyclical and change quickly. So while it’s supportable at the moment, it might not be supportable six months or a year from now.”

Among the companies Cuggino does like is Freeport McMoRan, a mining company in the beaten up area of hard assets. He says he likes it for its relatively low multiple of about 14 and dividend yield of 3.6%, which he says is better than a 30-year Treasury bond, and the payout is something less than 50% of earnings. “They have plenty of money for capex expansion.” He also likes financial services company State Street Bank, trading at multiples of 13 to 14 and a dividend yield of a little under 2%. It’s a financial company, but one that gets more money from fees and asset service than from loan products that depend on a company’s ability to milk high interest rates (which many banks, insurers and brokers can’t do right now, for obvious reasons).

Like Cuggino, Wong at Payden & Rygel is attracted to gaming company Wynn Resorts. CEO Steve Wynn “has a couple of casinos in the Strip, but more important, they have three casinos in the Macau province of China, which has become the gaming capital of the world,” says Wong. “It’s six or seven times the revenues of Las Vegas. We’re seeing a lot of gaming growth in that region. Wynn has three-quarters of revenue coming from Macau with the rest coming from Vegas. The beauty is that they’ve got attractive dividend yields of 2.5%. In addition, they have been paying out special dividends at the end of each year in addition to the regular dividend. When you factor that in, the dividend yield is 3.5%-4.5%, so with their success they’ve been able to pay out additional levels, which have been doubling. That’s not sustainable but …  it’s an indication of how much the regular dividend has been growing and that’s more a testament to [Wynn’s] success in running the company.”

Schoenstein, who co-manages the $5.4 billion Jensen Quality Growth Fund, says the fund focuses on companies that can deliver consistent growth, not just the highest-flying aggressive growers, which are more volatile. The fund doesn’t look at a company unless it has a consistent 15% return on equity every single year for 10 years. “That gives us a universe of just over 200 companies,” he says. And good dividend payers, rather than being a focus, are usually a pleasant side effect of that methodology. “Inside that subset, one of those things that’s very prevalent is a strong emphasis on dividends by the businesses because they produce a very high level of consistent free cash flow, and that’s the fuel that drives the engine.” Twenty-six of his companies pay about 2% dividend yields, not much different from the S&P 500, he says, but “the difference is that that dividends we have, the companies paying them are growing them at mid-to-high single digits or at double digit rates of growth.”

Household names like Pepsi stand out, he says: The company’s dividend is nearly 3%, supported by nice growth in its overall business “regardless of whether they have to fight soda taxes or obesity or whether they are fighting concerns about short-term emerging market growth trends.” Another company he likes is information technology company Automatic Data Processing. “It’s not a high-flying tech like a Google or a Facebook, but yet the business itself has proven to be resilient and fairly sustainable and allowed them also to pay a consistent dividend of almost 2.5% in terms of yield that is over and above what the business is doing.”

Financials are still totally downhill, says Silverblatt, pointing out the nightmare with Bank of America and other financial crisis disasters that impeded these companies’ abilities to pay dividends.

“Go back to 2007 and 2008, they almost accounted for a third of all dividends being paid,” he says. “But they went to a single digit. We now have 14%. We do not see them getting back to the 30% level, given that the Fed is watching them. Especially with Bank of America. That was a nightmare.” Bank of America had planned a dividend increase until May 2014, when it reported a $4 billion accounting error to the Fed and was forced to resubmit its plan.

Hogan says the larger financial companies are more at a disadvantage than they have been in the past, but the smaller banks don’t face the same degree of regulatory scrutiny and are able to take share from larger banks.

In any case, Fennell says that the steady search for yield is going to be unyielding—401(k) plans, 403(b) plans and the armies of aging baby boomers are going to be demanding it.

“It’s been interesting to see the outflows in the first quarter in this category,” he says. “It’s a pretty steady receiver of flows just due to its nature. I know a lot of defined contribution 401(k), 403(b)-type plans have some type of option like this in their lineup and it’s usually a pretty conservative way to go. The flows are usually on autopilot in a lot of these funds.”