Dividend stocks are coming back in style, Morningstar says. Here's how investors can play the trend.

• Dividend stocks were solid last year but still trailed the broader market.
• Cheaper valuations should help the group narrow the gap with large-cap growth.
• Here are four parts of the market that dividend-minded investors should consider.

Last year was excellent for large, growth-oriented stocks and those who invested in them.

Apart from that, results were mixed. Most parts of the market couldn't keep pace with the S&P 500, which is disproportionately swayed by mega-cap growth companies. In fact, the so-called Magnificent Seven stocks make up more than a third of the index, according to Goldman Sachs.

Dividend stocks were among the investments that fared admirably but underperformed in 2024. Morningstar's US High Dividend Yield Index composed of companies with above-average yields rose by a respectable 16.9% last year, though US stocks broadly climbed about 24%.

The high-dividend index's value tilt dragged it down relative to mega-cap growth, Alex Bryan, Morningstar's director of product management for equity indexes, said in a recent interview.

"As it's been pretty well documented, pretty much anything that's been underweight tech and underweight growth more broadly has had a hard time keeping up," Bryan told Business Insider. "And that's certainly the case when it comes to most dividend income strategies."

But Bryan and Morningstar strategist Dan Lefkovitz believe that's about to change, with the latter writing in mid-January that "changing market dynamics could benefit dividend investors."

The price is right for dividend stocks

Large growth stocks have long traded at a valuation premium, though their astounding recent success and significant sway has sent the US market's valuation soaring in the last year.

The market's forward earnings multiple, as measured by Morningstar's US Market Index, has ballooned from 13.9x to 22.5x from 2023 to 2024, according to Morningstar data sent to BI.

That valuation spike wasn't universal, as forward price-to-earnings (P/E) ratios contracted for two of the three major dividend-focused indexes that Morningstar tracks. And although the firm's US High Dividend Yield Index saw its earnings multiple jump substantially, it still trades at a major discount to the broader market.

Instead of buying low and selling high, many investors simply stick to what they know and what's working. In turn, money has steadily flowed into a handful of stocks that are household names, either directly or through passive investing vehicles like ETFs or mutual funds.

However, Bryan believes there will eventually be a major reversal into discounted companies.

"Increasing concentration — the narrow leadership among a handful of companies — probably is not going to continue indefinitely," Bryan said. "There should be mean reversion at some point. Our expectation is that when that mean reversion happens, the areas of the market that have perhaps not been as hot over the last few years, those might be better because they're more attractively valued."

Less flashy investments are poised to catch up or surpass large caps, in Bryan's view. That hunch is supported by history, as the equal-weight version of the S&P 500 has outperformed in 78% of 10-year periods in the last four-plus decades, according to Goldman Sachs.

Still, Bryan can't be certain that this is the year the gap between dividend stocks and the market closes.

"From a valuation standpoint, dividends look more attractive than they did a year ago, and that's partially because of the relative underperformance that they've had," Bryan said. "But like anything, it's tough to really time your entry points into certain areas of the market."

Dividend-paying companies could trail the S&P 500 again if interest rates stay higher for longer, since income-minded investors might be satiated by elevated yields in bonds and cash.

"If you're looking for high yields, you can get it from fixed income," Bryan said, adding that the asset class often carries less risk than equities.

Yields are higher right now because bonds are being sold in droves. Bond prices and yields move inversely. Lucky investors may lock in sizable yields before a big rebound, though as Bryan noted, trying to time the market is often a fool's errand.

Those who aren't comfortable with bonds in a higher-for-longer backdrop but still want income might find themselves gravitating toward dividend stocks.

"Bonds are certainly more competitive relative to dividends," Bryan said. "But if you look at dividend-paying stocks relative to the rest of the equity markets, I think they're becoming more attractive relative to other stocks."

4 top sectors for dividend investors

Those interested in dividends should look in four sectors that are known for their solid yields, Bryan said: energy, financials, healthcare, and consumer staples.

That's an even mix of economically sensitive and defensive groups, so investors who tilt toward those parts of the market shouldn't be caught off guard no matter what happens to the economy.

Financials could come under fire if interest rates go down and the yield curve flattens, Bryan said, though rate cuts don't appear to be on the horizon after a surprisingly robust jobs report.