Portfolio managers that focus on dividends deliver strong returns.

It wasn’t so long ago that investors preferred fast-growing companies that plowed every cent they made back into their businesses. But a growing number of managers are demonstrating that buying companies with significant and growing dividends is an effective way to beat the broader market -- and not just because of the income.

“Having a strong dividend policy imposes fiscal discipline in managing assets that can translate into superior financial and equity performance,” says Laton Spahr, portfolio manager of the $1.9 billion-in-assets RiverSource Dividend Opportunity Fund. That point of view has helped power strong results: Through May 18, Spahr’s fund had notched three-year annualized returns of 21 percent, compared with a 13.78 percent return for the Standard & Poor’s 500 index.

A survey of several dozen dividend funds tracked by Morningstar supports the merits of investing in companies that return cash to shareholders. Excluding real estate funds, the average total return of the group topped the S&P 500 by 49 basis points in the 12 months ended April 30 and 154 basis points over the trailing three years.

Spahr focuses on large-cap companies with consistent or rising dividends. One top holding is Altria, which at a recent $71 has bested the S&P 500 by an annualized 12 percent since he began buying shares in February 2004. Over the past five years, the cigarette maker has grown its dividend at an annual rate of 8.3 percent; its stock currently yields 5.1 percent. “The company’s strong excess cash flow provides excellent support not only for its current dividend but also for future dividend growth,” says Spahr.

Moudy El Khodr, senior portfolio manager of the $344 million-in-assets ING Global Equity Dividend Fund, is so committed to dividends as a barometer of future returns that he will sell a stock if its trailing 12-month yield falls below 3 percent. His fund, launched in 2003, has delivered three-year average annual returns of 23.1 percent.

One of El Khodr’s long-standing holdings is Singapore’s United Overseas Bank, which he bought in June 2004. This highly regarded retail and corporate bank is experiencing strong growth by exploiting its position in the fast-growing Pacific Rim. With a recent yield of 4.83 percent, the stock has delivered average annual total returns of 31 percent since El Khodr added it to his portfolio.

William Priest, co-founder and CEO of Epoch Investment Partners, which manages nearly $6 billion in assets, also pays close attention to dividends. But Priest, a former CEO of Credit Suisse Asset Management Americas, adds a twist to the standard thesis by favoring companies that are also paying down debt and buying back shares. To arrive at a measure he calls “shareholder yield,” Priest adds up the cash that companies devote to these three activities and looks for the ones that are spending the equivalent of at least 6 percent of their market capitalization. “We then interview management to make sure they are capable of sustaining their commitment,” he says.

Epoch employs the strategy globally.

A case in point is Essen, Germanybased

utility RWE, the third-largest holding in the firm’s $520 million-in-assets Global Equity Shareholder Yield fund, launched on December 31, 2005. RWE has a yield of 4.25 percent, a buyback program that seeks to retire 7 percent of outstanding shares and a commitment to cut debt by 1.6 percent. Since coportfolio manager Eric Sappenfield bought a stake in December 2006 equal to 2.2 percent of his fund’s assets, the stock is up nearly 4 percent.

Sappenfield also likes Belgacom, the partially state-owned Belgian telecom services provider, because of its strong free cash flow, equal to 12.8 percent of the company’s market cap; its stock buyback program, which last year retired 6 million shares equal to 1.7 percent of its average market cap; and its healthy 5.92 percent cash yield. Although Belgacom borrowed E1.65 billion ($2.22 billion) in 2006 to buy out Vodafone’s 25 percent stake in the Belgian operator’s wireless unit, the company has a track record of paying down debt. In late 2005 and early 2006, Sappenfield invested $13 million in the stock, which through May 18 had returned 42 percent.

Not all fund managers agree with Epoch’s emphasis on stock buybacks. Ben Fischer, lead manager of the $7.86 billion Allianz NFJ Dividend Value Fund, which has generated three-year annualized returns of 20.7 percent, says that share repurchases often don’t enhance performance because they are undertaken when companies feel rich and their stock prices are high.

A recent Morgan Stanley equity research report analyzing the stocks in the MSCI Europe index supports that contention. According to the authors, companies that have grown their dividends have on average outperformed the index since 1997; those that have instead returned capital through share buybacks have fallen short. How and why companies return cash, it seems, is just as crucial as the amount they choose to give back.

Assets Annualized
Fund ($ millions) Yield YTD Returns Returns
RiverSource Dividend Opportunity Fund $1,900 2.40% 10.77% 20.99%
ING Global Equity Dividend Fund 344 3.3 8.12 23.09
Allianz NFJ Dividend Value Fund 7,860 2.1 9.9 20.68
Epoch Global Equity Shareholder Yield Fund 520 3.3 8.95 NA
S&P 500 1.8 8.23 13.78
MSCI World Index 2.8 9.3 19.59
Data through May 18, 2007.
Source: Morningstar.