New Tricks for an Old Strategy
By Susanna Hamner

(Business 2.0) – It's a time-honored investment tactic: Buy stable, boring utility stocks, collect fat dividend checks. But today high-dividend stocks are more varied--and more lucrative--than ever. Thanks to a change in the tax code passed by Congress in 2003, most dividends are now taxed at a flat rate of 15 percent rather than being lumped in with the rest of your income. Because the change has made stocks that pay dividends more attractive to investors, 76 percent of the companies in the S&P 500 are now issuing them, up from 70 percent in 2003. But high-dividend stocks come with their own unique risks. Josh Peters, editor of Morningstar Dividend-Investor, tells us what to look for.

• PAY ATTENTION TO PAYOUTS. The higher the payout ratio--the ratio of dividends to earnings--the less cushion for dividends if earnings drop. A company distributing more than 80 percent of its earnings as dividends should raise a red flag, and cyclical businesses such as paper and steel may have difficulty maintaining a 50 percent payout.

• BE WARY OF BORROWING. If a firm is taking on debt to keep dividends high, it's a sign that management is hoping that operating cash flow will bounce back. It might not, so investors should be cautious.

• LOOK FOR STEADY GROWTH. Ideally, revenue and income from the company's core businesses should be growing by at least 6 percent a year on average--factoring in 2.5 percent for inflation and 3.5 percent for the long-term U.S. GDP growth rate. A company that's not keeping pace with the economy won't be around to pay dividends in the long term.

• BE PARTIAL TO "WIDE ECONOMIC MOATS." The term, popularized by investor Warren Buffett, refers to advantages that are hard for competitors to copy, like strong brand names and high switching costs for customers. Examples include American Express, Coca-Cola, and eBay, which are more likely to weather competitive threats and economic recessions.

• EXAMINE EXPANSION COSTS. The more a company spends on growth, the less money it has available for dividends. If you subtract capital expenditures from operating cash flow, that number should exceed the amount paid in dividends. If it doesn't, the company may not be able to finance growth while rewarding its shareholders. -- S.H.

THREE HIGH-DIVIDEND STOCKS TO BUY ...

... AND THREE TO AVOID

1) As of Aug. 4. 2) Microsoft began paying dividends in 2003. Source: Morningstar