HOW TO PLAY IT: Recession jitters? Dividends may not be answer

NEW YORK (Reuters) - Dividends, once considered the boring afterthought of the stock market, are now in vogue.

Investors are crowding into dividend-paying stocks on the theory that cash-rich companies like Microsoft are the new Treasury bonds, especially as they anticipate another year of slow economic growth, historically low bond yields and volatile trading ahead.

But it pays to pause and listen when everyone on Wall Street starts to whistle the same tune.

Investors following the herd have bid up prices of certain high-dividend paying sectors of the market, creating a crowded - and expensive - trade.

The utility component of the Standard & Poor's 500, which has historically had a low price to earnings ratio because of slow earnings growth, now trades at an earnings multiple 7 percent higher than the overall market.

Telecom stocks, another slow grower, trades at a P/E that is 30 percent higher than the broad index.

Boring has become expensive. Here are better ways to get income.

HEALTHY BETS

The high prices of utilities stocks have even dividend-fund investors looking for other options.

"You just can't imagine a utility costing 16 to 18 earnings, but that's what we're seeing," said Tom Forester, portfolio manager of the $220 million Forester Value (FVAL) fund.

Forester, who expects another U.S. recession in 2012, remains skeptical that cyclical dividend-paying stocks in industries like technology or industrials will offer solid returns.

He's moving more of his portfolio to healthcare companies like UnitedHealth Group. The company, which yields 1.4 percent, trades at a P/E of only 10.6 despite a 30 percent surge in its shares since January.

"This is a company that is going to grow earnings whether we're in a recession or not," he said.

UnitedHealth Group is undervalued because of lingering uncertainty about healthcare regulations and possible cuts in Medicare spending, Forester said.

He also likes drug companies like Bristol Myers Squibb, which yields 4 percent, Eli Lilly And Co, which yields 5 percent. "Both of these companies have Alzheimer's drugs in the pipeline that will give them tremendous upsides" that are not reflected in share prices, Forester said.

Vadim Zlotnikov, chief market strategist at AllianceBernstein, also likes companies like Eli Lilly.

"Concerns about austerity measures in developed markets have resulted in historically low valuations for healthcare," he wrote in a recent note to clients.

Rising healthcare spending in emerging markets like China, India, Brazil, Russia and Mexico will outweigh possible spending cuts in developed market, he said.

Vanguard Health Care (VHT) is one low-cost way to increase an investor's holdings in healthcare stocks. Its largest holdings are Johnson & Johnson, Pfizer and Merck & Co, which together make up 28 percent of the fund's assets.

Mark Lamkin, head of Louisville-based Lamkin Wealth Management, has a different take on healthcare.

He's buying healthcare real estate investment trusts (REITs) that own properties like hospitals, medical office buildings and nursing homes. "You can get a 6 percent yield or more in a demographic that's only going to expand," he said.

Two picks: Omega Healthcare Investors, which yields 8.8 percent and owns a mix of skilled nursing and rehabilitation sites, and HCP Inc, which yields 5 percent and owns mainly senior housing facilities.

ETF PLAYS

Investors who are concerned about the high prices of utility stocks are looking for companies that are expected to increase their dividends.

"Companies are cash rich, but there's not going to be a lot of opportunities for them to invest their money when growth is slowing," said Tony Zabiegala, vice president of Seven Hills, Ohio-based Strategic Wealth Partners. Many will choose to increase their dividends instead, he said.

Zabiegala holds dividend ETFs instead of building up large positions in any one company.

His favorites are Vanguard Dividend Appreciation (VIG), which yields 2.1 percent, and Vanguard High Dividend Yield (VYM), which yields 2.8 percent. Both funds hold relatively small positions in utility stocks. About a fifth of VYM's assets, for instance, are in consumer staples like Coca-Cola, Wal-Mart and McDonald's. Only 5 percent are in utilities.

Meanwhile, the Dividend Appreciation Fund (VIG) only holds companies that have increased their dividends for 10 consecutive years. Its top holdings are McDonald's, International Business Machines and Coca-Cola.

Michael Rawson, an ETF analyst at Morningstar, recommends the VYM fund over funds that offer higher yields.

"Super-high-yielding holdings are in severe risk of dividend cuts as we continue through difficult economic times," he noted.

HIGH-YIELD OVER HIGH-QUALITY

Historically low yields on Treasury bonds have investors looking elsewhere for income. The 10-year Treasury, for instance, yields just 1.92 percent. The S&P 500, by comparison, yields 1.96 percent.

"We are going to be an extraordinarily low interest rate environment for some time," said Gary Pollack, head of fixed income at Deutsche Bank Private Wealth Management.

Those low yields have led Mark Lamkin, the Kentucky wealth manager, to sell off all of his long-term Treasury bond holdings. He's replacing them with higher-yielding corporate and municipal bonds.

He's been adding to his position in the SPDR Barclays Capital High Yield Bond ETF (JNK), which yields 7.4 percent. The fund costs 41 cents per every $100 invested and tracks the U.S. high yield corporate bond market. The majority of its holdings mature in 5 to 10 years.

For municipal bonds, Lamkin picks the Franklin High Yield Tax-Free fund (FRHIX). The mutual fund, which yields 5.1 percent, has half of its assets in bonds rated investment grade or higher.

(Reporting by David Randall; Editing by Walden Siew)