Changing one’s style stripes when markets crater may provide a brief boost to returns but in the long run it can handicap a portfolio manager’s potential.

Since financial markets tend to rise and fall in a cyclical fashion timing those peaks and valleys can be a fool’s errand. Chasing performance—an equally debilitating exercise—can often lead investors to buying at the top of the market. As such, staying true to a time-tested investment process may be more likely to yield strong , long-term performance.

Mutual fund analysts frequently cheer fund managers who “stick to their knitting” or have deep conviction in their investment philosophy, a characteristic that is synonymous with NFJ Investment Group. Ben Fischer, co-founder and portfolio manager at NFJ, believes firmly that underpriced, out-of-favor securities that pay dividends tend to outperform the market over time even though they may underperform the market when low quality growth stocks are in favor.

NFJ has adhered to this “deep value” approach through both bull and bear markets since the Dallas investment firm was founded in 1989. And while some of the funds NFJ manages have endured a difficult stretch in recent months, they have generally performed well over full market cycles.

“We base our emphasis on high-quality, dividend-paying stocks on results,” Fischer says. “We have a strong 20-year track record and although we’ve had periods of underperformance along the way, the fluctuations [to the downside] have been short-lived.”

Despite having a strong absolute return year-to-date, NFJ has underperformed its benchmark and its peers in 2009, in part, because it was underweight low-quality financials. During the six-week period from March 9 through April 17, financials within the Russell 1000 Value Index powered the benchmark to a 73.6% total return, contributing 12.8% to its overall return for the period. Among the biggest movers were companies that needed relief from the government to survive, however.

NFJ invests in low-priced, income-producing stocks with attractive fundamentals and therefore either avoided owning those companies or sold out of them. The ensuing rally was driven by speculators taking risk rather than by solid fundamentals. This so-called “junk rally” hurt the Allianz NFJ Dividend Value Fund due to its higher quality, lower beta bias and its aversion to buying stocks simply because they’re cheap—a classic value trap.

Fischer did not want to own a lot of the banks due to his fear of nationalization of the banking system or worse—bankruptcy. Bank of America, which saw its shares jump 248% during the six-week rally that began in March, is a prime example of a position that was sold based on this threat. In February, the bank slashed its dividend to a penny a share, posted a $2.39 billion loss for the fourth quarter of 2008 and received a $20 billion capital infusion from the government.

Another stock that was sold ahead of the rally was Lincoln Financial, which NFJ believed would survive its liquidity crunch but believed there was too much uncertainty surrounding Lincoln’s balance sheet and its ability to pay off several hundred million dollars in short-term commercial paper. Meanwhile, Wells Fargo was sold after it reduced its dividend 85% from 34 cents a share to a nickel a share.

Nevertheless, the government bailout helped these struggling financial institutions stay afloat and set the stage for a rebound. “The hot performance is coming from low-quality companies,” Fischer says. “Some really good, high-quality companies are lagging.”

Dividends, a key tenet of NFJ’s investment philosophy, have come under scrutiny with a slew of companies suspending or cutting their dividend payments to offset steep losses on their balance sheet in the wake of the credit crisis. In the second quarter of 2009 alone, 367 companies slashed their dividend payments, according to Standard & Poors.

But despite distressed market conditions and a shrinking universe of dividend paying stocks, a select group of companies are raising dividends. As of June 30, Allianz NFJ Dividend Value had 19 stocks that have increased their dividend payment this year and 25 that have increased their dividend payment over the last 12 months including 3M, Altria and Waste Management.

Growing dividends amid significant contraction in asset prices and corporate balance sheets is an indication that a company is fiscally fit. “The historical argument in favor of dividends is still intact,” Fischer says. In fact, given the likelihood of a lower-return environment and the increasing number of baby boomers headed for retirement, the case for dividends is stronger now than it has ever been, he says.

Dividends have long been a sign of quality in terms of strong balance sheets and more consistent cash flows. They are also viewed as a better gauge of a company’s fiscal health than earnings because earnings are more susceptible to wide fluctuations and can be overstated, revised or manipulated. In addition, they serve as a backstop in down markets. Some investors use dividends as a hedge against inflation, a strategy that may prove useful as a mounting budget deficit and heft of government stimulus.

While past performance is no guarantee of future results, historical evidence shows dividend-paying stocks have outperformed non-dividend stocks. The Allianz NFJ Dividend Value fund enjoyed nearly a five-year period of solid gains after struggling in the wake of the 2000-2002 bear market. Fischer draws a parallel between the current environment and 2003, when the fund’s struggles precipitated an extended period of outperformance.

Fischer is confident that dividend payers are once again poised to perform well coming out of the downturn citing increased cash flow and the market’s tendency to pay a premium for quality credits. Ultimately, the long-term benefits of sticking with quality outweigh the short-term drag on performance that they must endure at the tail of end of a bear market, he says. “We’re close to the end of the junk rally,” he says.

Despite the bloodletting in equities in 2008 and the expectation that market volatility will remain high for the foreseeable future there are still opportunities for stock pickers to add value to clients’ portfolios. Investing in quality companies—those with strong balance sheets and high dividend yields—can be a difference maker even when markets are depressed or flat. Indeed, more than 75% of the alpha NFJ has generated has come from stock selection.

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