NEW YORK (CNN/Money) -
Dividends are in vogue once again. The shares of companies that dole out quarterly payments to shareholders have held up much better this year than stocks without the security of a regular income.
But dividends are not guaranteed -- companies choose to pay them out of earnings. If a firm runs into financial trouble, the dividend could get cut or even eliminated. (Several well-known companies have cut their dividends this year, including DaimlerChrysler, Heinz, and a trio of struggling energy companies, Dynegy, CMS Energy and Williams.)
There could be more unkind cuts to come. On Monday, a Merrill Lynch analyst downgraded banking giant J.P. Morgan Chase and predicted that the company will lower its dividend, possibly by as much as 50 percent, within the next few months.
Dividend paying stocks have been embraced by investors as of late because they offer added income, similar to bonds. And if a company is able to continually pay a dividend even during tough times, it stands to reason that it should be fairly stable. With all this in mind, how can investors find companies that won't cut their dividend?
Yield isn't everything
Companies that have increased their dividend steadily throughout the past few years are likely to keep doing so, says Jim Denney, manager of the Electric City Dividend Growth fund, a fund run by money management firm Mohawk Asset Management. Denney says that consistency is more important than a big yield.
For example, Home Depot has a dividend yield of just 0.6 percent, well below the average for the S&P 500 of 1.7 percent. But Home Depot's dividends have increased an average of 27.2 percent over the past five years. Denney owns Home Depot in his fund.
Linda Duessel, manager of the Federated Equity Income fund, says that financially strong companies with little debt are the companies that are in the best position to increase their dividend. In addition to Home Depot, she says that General Electric and Procter & Gamble are companies that investors can rely on for steady dividend increases. Each has boosted its dividend more than 10 percent a year on average during the past five years.
Conversely, investors probably should be wary of companies that are undergoing tough times. If a company's earnings are under pressure or if it has a high amount of debt, than a dividend cut is a likely way for the company to try and conserve cash.
That was the case for DaimlerChrysler, which decided to cut its dividend after reporting a large drop in profits for 2001. And considering that Williams and Dynegy are both expected to report earnings decreases of more than 80 percent, it's no surprise that they felt the need to cut back on their dividends.
Keep an eye on earnings
To that end, Denney says large financials like J.P. Morgan Chase and FleetBoston Financial could be candidates for a dividend cut because of concerns about risky corporate loans and exposure to international markets. J.P. Morgan Chase and Fleet Boston yield nearly 6 percent.
| * as of September 9 |
| Source: CNN/Money|
But Denney says that the sell-off in financials has created opportunities for less risky banks with a history of dividend increases. Two that he owns in his fund are Banknorth, a New England franchise based in Maine, and Community Bank System, based in upstate New York. Each has increased its dividend by approximately 10 percent a year for the past five years. Banknorth has a yield of 2.3 percent while Community Bank System's is 3.7 percent.
Utilities and telecoms have also been battered as of late, and Duessel says she thinks some companies that have steadily hiked their dividends have been unfairly punished. In the utility sector, Duessel likes Duke Energy, with a yield of 4.4 percent. She says it is a plain vanilla energy company that has not been burned by aggressive accounting practices and its dividend has increased at a 7 percent clip over the past five years.
And Duessel thinks the three Baby Bells -- Verizon, SBC Communications and BellSouth -- have relatively safe dividends as well, despite the troubles in the telecom sector. That's because they are not as debt-laden as many other telecoms.
Denney owns two of the Baby Bells in his fund, Verizon and SBC. He would be wary of other high-yielding telecoms like Sprint though. The long-distance company's stock offers a healthy yield of 4.7 percent. But long-distance carriers have been struggling with massive debt loads and sluggish revenue growth as their business becomes more and more of a commodity. AT&T already slashed its dividend in 2000. And unless you've avoided all forms of media for the past few months, we don't need to tell you what happened to WorldCom.
Another thing to look at is a company's payout ratio -- the annual dividend divided by earnings for the past twelve months. So if a company pays a dividend of $2 a share and it earned $4 a share, its payout ratio is 50 percent.
Denney says that his rule of thumb is to avoid companies that pay more than 60 percent of their earnings as a dividend because they tend to have the least flexibility to increase their dividend. And if they run into even minor financial trouble, they might cut it. Heinz, for example, had a payout ratio above 60 percent before it decided to spin-off some businesses and cut its dividend.
Finally, a high yield itself could be a warning sign. After all, one of the components of a dividend yield is the stock price. So if a stock plummets and the company's dividend does not change, its yield will surge. But rather than celebrate the fact that the yield is high, investors might want to be more concerned with why the stock has fallen so much.
"It's been quite popular to just go after companies with a high yield," Duessel says. "But if it's unusually high it's a signal that it's going to be cut."