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Dividend stocks get new respect

November 21, 2011, 3:00 PM UTC

T. Rowe Price’s Tom Huber says the category makes more sense than ever and explains what he’s buying.

Tom Huber started managing the T. Rowe Price Dividend Growth fund (PRDGX) right around the time the tech bubble burst in 2000 and has seen plenty of market tumult since then. Through it all, the 45-year-old Wisconsin native has stuck with the slow and steady strategy of betting on companies with strong balance sheets and rising dividends. When stocks were soaring, that might have seemed boring. But with the markets seesawing wildly, its appeal is clear. The $2 billion fund has consistently beaten the market over the past decade, with a 4.1% annualized return, vs. the S&P 500’s (SPX) 3.2%. Huber makes the case for dividend stocks — including struggling bank shares — and discusses what he has been buying. Edited excerpts:

With the current market volatility, dividend-paying stocks look attractive to skittish investors. Is now the time for a dividend strategy?

The idea of getting some level of return, regardless of the direction of the stock price, is at the top of investors’ minds right now because of the environment. There’s a lot of skittishness, as you called it, or nervousness. And with the low level of interest rates, it’s very difficult for investors to find competitive yields without taking undue risks. I think dividend growth is an investable strategy over market cycles, but there are periods when it’s going to do better than the market, and now is probably one of them.

Companies have been stockpiling cash since the financial crisis. What has been the impact on dividends?

We’ve seen a nice recovery since the big recession, when financial services pretty much eliminated their dividends, and other more cyclical companies took a hit as well. The payout ratio for the S&P 500 is now hovering at 30%, which is historically low. The historical rate is closer to 50%. There is capacity for dividend growth.

Financials make up 13% of your portfolio, even in a tough year for them. Why?

Financials are historically very good dividend payers and very good growth stocks. I owned a lot of financials going into the crisis. We took our hits, certainly, but we avoided the biggest disasters. I had minimal Citi (C) shares, no AIG (AIG), and never owned Bear or Lehman. At this point, we’ve consolidated into names like U.S. Bancorp (USB), Wells Fargo (WFC), and J.P. Morgan Chase (JPM). USB and Wells, in particular, are predominantly U.S. banks, and they’re very well-capitalized, well-managed companies. Both have reinitiated dividends. Banks are all suffering right now, but we want to be in those stocks that are going to act rationally in a difficult environment and come out strongly on the other side.

Pfizer is your largest holding, and was the fund’s top performer earlier in the year. But with top-selling Lipitor coming off patent, it doesn’t seem like a growth play. What’s your thinking?

This wasn’t such a growth idea, but one where we thought there was a lot of value, an attractive yield, and a tremendous amount of free cash flow over the next several years. The company went through a management change, and the new management has been a breath of fresh air in terms of allocation of capital to shareholders. We’ve seen a healthy level of buybacks, dividends, and dividend growth. Pfizer (PFE) is facing big patent issues, but that’s no secret. It has a pipeline with a few new drugs going through the FDA that should help offset some of the loss. I think it’s a safe investment, and one where we see fair value of $24 to $25 [compared with a recent $20]. On top of a 4% yield, that’s a nice return.

What have you been buying recently?

One that’s moved into the top five is PepsiCo (PEP). We have a valuation bias, so when we notice a company of Pepsi’s quality that seems to be struggling, we’ll do the work. It has underperformed relative to its peers, in part because of losing some market share domestically to Coca-Cola. I think it is now making the right decisions to increase marketing and ad spend. If you look out a few years and assume a reasonable multiple, you can make 15% to 20% without taking on undue risk. Another one in the consumer area is Kohl’s (KSS), the department store chain. It just this year initiated its first dividend, and the yield is under 2%. It was your classic rapid-growth darling stock that matured. It had grown the store base 15% to 20% a year, year in and year out. Eventually the market can’t support that level of growth. Kohl’s is a very well-managed company and figured it out very quickly. It will now grow square footage only 2% to 3% a year. It won’t be investing in stores that wouldn’t pay off for us as shareholders. For us, in an economy that’s hardly growing, 5% to 6% topline growth is not bad.

You’ve made a big bet on industrials. What do you like there?

United Technologies (UTX) [which makes everything from air conditioners to elevators to helicopters] is well positioned in the industrial world and is a good way to play global GDP growth. It does about 20% of its business in emerging markets. That’s important now, and it’s only going to become more important. We think it could earn close to $6.80 in 2013. It trades around 11 times that number, and it could get a higher multiple in an environment where people feel better about the global economy.

This article is from the December 12, 2011 issue of Fortune.