Time to Ditch Dividend Stocks?

These income generators have been attracting plenty of investors, but may be too rich for some blood.

One man handing a stack of money to another man.
By + More

Investors who want to avoid value traps might be well-served to extend their search. Typically, a dividend-related strategy gravitates toward large-cap stocks, notes Heartland Funds analysts, in a note.

Rarely are dividends equated with small-cap stocks, even though some 45 percent of the companies in the Russell 2000 Value Index pay a dividend.

[See Financial Stocks: Do You Dare?]

Why dividends at all? It's the frothy periods that prompt some analysts to question why investors become so focused on dividends at the expense of other stock-picking factors—and often without consideration of capital-gains tax implications for collecting dividends. Expiring tax cuts could raise taxes on dividend income next year.

Chuck Akre, chief executive officer and chief investment offer of the $1.1 billion Akre Focus Fund (AKREX), prefers companies that turn their excess cash right back into the business. For Akre, that increases his chances of a much faster return on investment.

"Since we are trying to compound our capital at an above-average rate, our natural preference is to find businesses which can reinvest all excess capital. In fact, paying out dividends is decidedly second choice, as it diminishes the rate of compounding possible," says Akre. "The true measure of the successful investment scheme is the real economic value per share."

Akre imparts his "three-legged stool" approach to selection: 1. strong management; 2. above-average free cash flow; 3. ability and willingness to reinvest cash flow back into the business rather than paying dividends.

And the overlay to that stool? Valuation. If the three features are in place, Akre will tolerate high valuations rather than sell a company to reduce risk.

"If I have one of these great compounders, I'm likely to continue to own it through thick and thin knowing that periodically, it's likely to be undervalued and periodically likely to be overvalued," he says. He's invested in credit-card issuers Mastercard (MA) and Visa (V) and credit-ratings firm Moody's (MCO) because their fee-collection models qualify them as the "defensive cash generators" that the fund leans toward. He includes insulation against a renewed economic downturn with discount retailers like Ross Stores (ROST) and Dollar Tree (DLTR).