Dividends, which historically have made up between 40% and 50% of total stock market returns, will continue to be coveted by investors under the slow-growth conditions that appear likely in the coming year, according to Hersh Cohen, co-chief investment officer at ClearBridge Investments and one of the co-managers of the ClearBridge Equity Income Fund.

Cohen believes that stock market performance in 2015 is more likely to resemble the measured progress of 2014 than the euphoric bull market of 2013. Under such a scenario, dividends would make up a relatively larger proportion of total return than they do in a more robust bull market.

“In 2013, the market was up five times as much as corporate earnings,” he says. “Normally, over a reasonable period of time, stock prices tend to move more in line with earnings growth. If that happens in the coming year, we should see market returns in the high single digits.” Given the absence of the euphoria in the market and valuations that aren’t out of line with historical norms, he believes a market meltdown is unlikely, although periodic corrections in certain sectors will provide some space for bargain hunting.

To Cohen and other dividend fans, tamer returns aren’t necessarily a bad thing. “The potential for capital appreciation is wonderful but inherently inconsistent,” says Cohen. “Dividends tend to be more predictable, and stocks remain the asset category of choice for income growth.”

Despite his relatively optimistic view, Cohen admits that it is harder for him and his co-managers, Michael Clarfeld and Peter Vanderlee, to find stock bargains for the value fund than it was a few years ago. The number of stocks participating in market upturns is narrowing, making stock selection critical. And while he classifies today’s price-earnings ratios as “about normal,” he believes further multiple expansion for most stocks will become more difficult after such a long bull market.

Another issue is that dividend yields for the market are about half what they were a few years ago, when roughly half of the stocks in the S&P 500 index yielded more than 10-year Treasurys. Today, about 30% of them do. For many investors, comparatively low rates on investment-grade and Treasury securities are helping keep the dividend story alive. But a sharp increase in interest rates could draw investors from dividend-paying stocks by making bonds more attractive.

The 73-year-old Cohen believes such an increase is unlikely to happen, at least in the near future. For one thing, the pace of economic growth isn’t as healthy as government reports seem to suggest. As evidence of this, he cites weak retail sales, which remain sluggish as consumers battle heavy debt loads and households continue to borrow to finance purchases. With the stagnant wage and job growth, the progress in the housing market appears to be stalling, and in areas where prices have risen, affordability remains an issue. And while the sales of autos have picked up, the subprime loans used to purchase them could spell trouble down the road.

To Cohen, the main surprise for 2014 was the market’s ability to shrug off terrorist activity and political events and focus on strong corporate earnings, dividend increases and merger and acquisition activity. He remains hopeful investors will maintain that focus this year, but believes falling oil prices have the potential to deliver surprises.

“On the one hand, lower oil prices help consumers,” he says. “On the other, the energy industry produces a lot of jobs that could go away if prices fall too low. We’ll have to see how this plays out.”

Conservative Leanings
Cohen and his co-managers, who can invest in companies of any size, prefer the mega-cap and large-cap names that dominate the fund because of their strong history of paying dividends and their financial strength to raise them in the future. The portfolio, which features 73 companies with a weighted average market capitalization of $130 billion, is filled with familiar blue-chip names such as Berkshire Hathaway, Microsoft, Johnson & Johnson, Home Depot and Raytheon.

The $6 billion fund has a number of other conservative leanings, including a preference for companies that have consistent business models with predictable revenue, strong free cash flow and plenty of money on hand to increase dividends. It spreads its bets widely among sectors, with industrials representing the largest one at 16%, followed by financials at 14%, information technology at 13% and consumer staples at 8%. At 32%, its annualized turnover is less than one-third that of the average equity fund.

Morningstar analyst Shannon Zimmerman pointed out in a report that the fund’s cautious leanings can tether returns in strong bull markets, which is what happened in 2013. At the same time, the fund has captured only 68% of the market’s downside moves over the last five years while participating in 81% of its upside. Its standard deviation, a measure of volatility, has also been well below that of both the overall market and its large-cap value peers. “Taken together, though, that profile adds up to risk-adjusted success,” Zimmerman concluded. “The fund is doing what it’s designed to do.”

Cohen says the fund’s goal isn’t to keep pace with the S&P 500 or any other index, but to “invest in a way that is consistent with our clients’ goals for this portfolio, with much lower volatility than the market.” All three managers have substantial financial commitments to the fund, which they believe underscores their mission to participate in stock market gains while cushioning downturns.

In this portfolio, the challenge is finding a combination of dividend-paying stocks of quality companies with dividend yields high enough to make a dent in overall returns. That was easier a couple of years ago when plenty of stocks were yielding 4% to 5%, according to 37-year-old co-manager Michael Clarfeld. Now, yields in the 2% to 3% range are more standard.

The fact that industrial stocks represent the fund’s largest sector weighting may sound odd, given that the team typically avoids deeply cyclical sectors that are highly sensitive to changes in the economy. But, according to Clarfeld, “there are some industrials out there with lower cyclicality and strong capacity for dividend growth.”

One of those is fund holding PPG Industries, the world’s largest producer of paints and coatings for everything from airplanes to houses. “This is a very easy-to-understand investment,” says Clarfeld. “There’s really nothing that can replace paint. And a house needs to repainted at least every 10 years, regardless of whether the economy is doing well or not.” A substantial part of its sales come from emerging markets, which should help drive growth.

Another longtime industrial holding is 3M, which has been increasing its dividends at a healthy clip over the last few years. The managers also like the company’s generous allocation of revenues to research and development, its high return on capital and its innovative and expansive product roster, which includes office, health-care and electronic products. The stock has a dividend yield of more than 2% and has grown dividends at a 5% annual rate over the last five years.

Clarfeld cites Kimberly-Clark’s diverse “no-fat” product line, which includes paper products such as tissues and diapers, as a recession-resistant business. The company has a high return on capital and uses its ample free cash flow to expand into emerging markets such as China, buy back shares and increase dividends. A global business with a dominant franchise in many markets, Kimberly-Clark derived 49% of its 2013 sales from North America, 37% from Latin America and Asia, and 14% from Europe.

American Express became part of the portfolio in 2014. With a presence in more than 130 countries, Amex is the world’s largest credit card company by purchase volume, and its cardholders, who have highly desirable credit profiles, spend an average of four times more than holders of MasterCard and spend three and a half times more than Visa cardholders. Clarfeld points out that, unlike other credit card companies, American Express makes most of its money from recurrent merchant fees, which are higher than those of its competitors, rather than interest from less predictable lending fees and revolving credit balances.

One of the few biotechnology companies to offer dividends, Amgen is another relatively new addition to the portfolio. A global leader in biologics manufacturing, the company has a long track record of delivering high-quality medicines, strong free cash flow and a solid drug pipeline. According to its website, it has increased dividend payments by 118% since 2011 while reducing its share count by 16% through stock buybacks.