How BlackRock's dividend fund plays a crowded field

When Robert Shearer took over the BlackRock Equity Dividend Fund (MDDVX) 10 years ago, dividends were often regarded as the boring afterthought of the stock market. Since then, he's steered the $24.5 billion fund to a 9.6 percent annualized return, a performance better than 98 percent of the funds in the category, according to Morningstar.

Yet with the 10-year Treasury yielding a historically low 1.7 percent, dividends are no longer sleepy. Investors are crowding into dividend-paying stocks to generate income and stay a step ahead of inflation.

Dividend funds have attracted net inflows of $20.8 billion for the year through September 19, according to data from fund research firm Lipper, a Thomson Reuters company. All equity funds have garnered $32.3 billion in new money over that same period.

That has some analysts saying that dividend-paying companies in high-yielding industries like telecommunications have become expensive. But Shearer says he is still finding attractive opportunities, in part by focusing on companies that look able to increase their dividends in the future.

"If they were expensive, then we would not be able to find these high-quality stocks" that are trading for less than the benchmark index's average, he said.

To stand out from the crowd, Shearer takes a value manager's approach to his portfolio. He only buys companies that are currently paying dividends, have strong balance sheets and whose production costs are in the lowest quartile of their industries.

This focus on a company's costs, rather than its dividend yield, is unique in that Shearer plans for long-term investments. Low production costs are essential, he says, because they can protect companies from abrupt business cycle downturns. These companies "will have the best margins," which allows the fund to make long-term bets more confidently.

The fund's turnover is just 5 percent a year, ranking among the lowest of actively managed mutual funds.

Companies must also show the potential for future dividend increases by posting strong earnings growth, one reason the fund is top-loaded with companies like Caterpillar, Deere & Co and General Electric that have growing businesses in emerging market countries like China.

Caterpillar, for instance, makes about 3 percent of its revenue in China and the company expects it to be its fastest- growing market. The Chinese economy expanded 7.6 percent in the second quarter, its smallest growth rate in more than three years.

Shearer is not overly concerned about China's slowing growth rate, pointing to Beijing's September 7 decision to fund $150 billion in new infrastructure projects. China had been slow to approve new projects in the past, he said, and should increase its infrastructure spending next year.

Caterpillar trades at a price-to-earnings ratio of 10.3, compared with a roughly 14 P/E ratio for the broad Standard & Poor's 500 index. The company's shares are up just 2.1 percent for the year to date despite a broad 16 percent rally for the S&P; index. It offers a dividend yield of 2.2 percent.

Another way Shearer looks to move away from popular - and expensive - companies is by adding to his positions in large and unloved financial companies. He expects these companies to increase their dividends, though he remains cautious on the sector. With about 2.5 percent of assets each, Wells Fargo and JP Morgan Chase currently make up the fund's third- and fourth-largest positions.

While these and other firms have been able to increase their dividends, Shearer says "their ultimate earnings power is not clear at hand yet" because of unfolding regulatory changes.

Wells Fargo trades at a P/E of 11.6 and offers a dividend yield of 2.5 percent. It is up 27.7 percent year to date.

Todd Rosenbluth, a fund analyst at S&P; Capital IQ, says many high-quality dividend paying stocks look expensive, which could hamper Shearer's ability to maintain his strong performance.

"The track record is a bit uneven for this fund," he said, noting that the bulk of its outperformance came in 2007, when it bested the S&P; 500 by nearly 9 percentage points, according to Morningstar.

Shearer says he is optimistic that large technology companies will continue either to initiate dividends or raise their payout ratios. His ninth-largest holding, International Business Machines, accounts for 1.9 percent of his portfolio and offers a 1.65 percent dividend yield.

Other technology companies could follow, he says. Apple, for instance, announced on March 19 that the company will begin issuing a quarterly payout of $2.65 per share.

"This is something that will definitely be on our radar screen," said Shearer.

The BlackRock Equity Dividend Fund yields 1.8 percent and some investors will pay a 5.25 percent sales load. It is up 9 percent for the year, compared with a 16.1 percent gain in the S&P; 500, and charges annual expense fees of $1.02 per $100 invested in the fund.

(Reporting By David Randall; Editing by Walden Siew and Dan Grebler)