Dividends: The most income at the least risk

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(Money Magazine) -- Dividend investing used to be really simple. Whether you were retired and needed the quarterly cash payments your stocks threw off for current income or you were a conservative investor simply looking to reinvest those dividends to generate a bit more growth, you bought these Steady Eddies with the intention of holding them for years - if not for the rest of your life.

The logic was compelling: Dividends have historically accounted for more than 40% of the stock market's total returns, and dividend-paying shares trounced nonpayers by more than five percentage points a year between 2000 and 2007.

But steady, as you now sadly realize, is hardly the way to describe the performance of dividend-paying stocks in 2008. Not only did they sink with the rest of the market, a record number cut or eliminated their payouts last year, including once dependable income producers such as Bank of America, Citigroup and General Motors. "Those cuts were painful because the companies are so large and widely owned," says Josh Peters, editor of Morningstar's DividendInvestor newsletter.

So is it time to give up on this strategy? Not in the least. At a time when the interest rate on long-term Treasury bonds is barely more than 2%, stock dividends still matter - maybe even more now that the S&P 500 is yielding around 3%. But you may need to adapt your approach to the changed landscape. Take the following steps to grow your income and cut your risk.

If your dividend checks are shrinking, it's probably because your portfolio is weighted too heavily in the financial sector. Even though banks, brokers and insurers represent just 13% of the S&P 500, they generate about a third of all dividends, making them by far the market's biggest group of payers.

Unfortunately, they also accounted for more than three-quarters of the 62 dividend cuts in the S&P last year, erasing $37 billion in income. No wonder "investors have lost confidence in the dividend-paying ability of this sector," says Mike Reckmeyer, co-manager of Vanguard Equity Income.

Since many financial stocks have stopped sending you checks anyway, don't feel bad about dumping the deadbeats and diversifying into other sectors, many of which have been boosting their payouts (overall, there were 236 dividend hikes last year). If you're worried about capital-gains taxes, remember that financial stocks have been hit hard. Many are showing losses over the past 10 years. This offers you a unique opportunity to sell long-term holdings and remake your dividend portfolio with little or no tax consequence.

Start with stocks that drastically cut or eliminated their payments and whose prices are cheaper than when you bought. Once you've sold and realized the capital losses - which can be used to offset future taxable gains - think about rotating your portfolio into other sectors. For dividend stalwarts with higher yields than the S&P 500, check out the table at right.

How can you be sure you're not about to step into a stock that's on the verge of cutting its payments? Simple: Start with companies with lots of cash, and then check out their payout ratios. It's easy to calculate. Just divide a firm's annual dividends per share by the company's earnings per share. For example, at the start of 2008, Walmart (WMT, Fortune 500) was paying 88 in annual dividends per share while earning $3.13, making for a modest payout of 28%.

While you might think a higher ratio is preferable - since that implies the company is willing to kick back to shareholders a greater share of profits - a high figure is also a sign that a firm could be straining to meet obligations. After all, if it takes almost all of a company's earnings to pay shareholders, that would put the firm under great pressure to cut payments if faced with an unexpected shortfall. Case in point: the New York Times Co. (NYT) Its ratio was a higher-than-average 60% in 2007. Not surprisingly, when the Times' profits plummeted in 2008, the media company was forced to cut its dividend by 74%.

Ratios vary by industry, but the average for U.S. stocks is about 40%. The sectors with the highest percentages are telecommunications (72%); consumer discretionary, which includes automakers and home builders (54%); and financials, where companies paid more in dividends recently than they earned. (Hint: More dividend cuts are on the way.) Conversely, you'll find some of the lowest ratios - or the safest opportunities - in energy (15%), technology (18%), health care (30%), materials (34%) and industrials (37%).

In the same vein, try to avoid the absolute-highest-yielding stocks as well. Remember how yields are calculated - by taking a company's payments per share and dividing that number by the stock price. This means yields can be high either because dividends are growing or because share prices are cratering. If it's the latter, there's a real chance of a dividend cut ahead. That's why Todd Ahlsten, manager of Parnassus Equity Income, says his radar goes up whenever a stock's yield hits 6% or 7%.

If you're investing through a mutual fund, consider equity-income portfolios, a conservative type of dividend fund that tends to yield more than the S&P 500 but generally avoids the highest payers. A typical equity-income fund yields around 3% to 4%, a good target for conservative income investors.

One of the best low-cost examples is Vanguard Equity Income (VEIPX). If you're more interested in long-term growth than current income, focus on funds that invest in dividend growers. These are companies that are financially strong enough to raise their dividends going forward but that don't necessarily pay the highest yields. Low-cost funds with strong track records that follow such a strategy include Vanguard Dividend Growth (VDIGX) and T. Rowe Price Dividend Growth (PRDGX).

Besides financials, the consumer discretionary sector looks risky for dividend investors, says Paul Alan Davis, co-manager of Schwab Dividend Equity. So what sectors look safer? Combined, consumer staples, energy, health care, industrials and tech accounted for just two cuts last year vs. 124 dividend increases.

One group Davis likes in particular is health care because of the strength of these firms' balance sheets. "It's pretty rare you would hear Bristol-Myers, Johnson & Johnson or Pfizer asking for bailouts," he says. Granted, it's unclear how pending health-care reform will affect the industry (see the box). But a company like Johnson & Johnson (JNJ, Fortune 500), which has boosted payments every year for at least 25 years, should be fine with its 40% payout ratio, about half that of Pfizer's.

In 2008 the sector with the best ratio of dividend hikes to cuts was industrials - and that was in a recession. If the economy worsens, this group will no doubt be hurt. But slow-and-steady growth companies such as Dover Corp. (DOV, Fortune 500), an industrial conglomerate with a low 30% payout ratio, are likely to continue to make distributions. And Dover has boosted its dividend checks every year for the past half-century.

Don't limit your search to the U.S. Blue-chip foreign stocks in industrialized countries ranging from Australia to the U.K. are yielding two to five percentage points more than the S&P 500. This is especially true in Western Europe, where the yield on the MSCI Europe Index, which tracks stocks in 16 developed markets in the region, stands at a healthy 5.7%.

So far, dividends haven't been cut in Europe as much as in the U.S. While that could certainly change, "the Europeans have more of a dividend orientation than the U.S.," says Reckmeyer. The easiest way to invest in foreign dividend payers is through a diversified mutual or exchange-traded fund. For low-cost options paying generous yields, glance over to the right.

If you don't need the cash payments your stocks are throwing off, reinvest them regularly. We can't stress that enough. You'll find that a surprisingly large chunk of your long-term growth will come from the compounding of these dividends. T. Rowe Price studied how buy-and-hold investors did in the S&P 500 between 1980 and June 2008. Even though stock yields fell during this stretch, the growth of reinvested dividends accounted for more than 50% of the S&P's returns.

True, dividends didn't protect you that much in the past 12 months, says Burns McKinney, co-manager of Allianz NFJ Dividend Value. "But look at equity market returns over the last decade," he says. "Any gains you had came from dividends."

Indeed, over the past decade the S&P 500 lost around 12% in total. But had you invested in the dividend-oriented T. Rowe Price Equity Income (PRFDX), which is in the Money 70, our recommended list of funds and ETFs, you would have been up 21% over the past 10 years.

It's a clear sign that dividends still do pay.

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