Invest for income: How to do it now

(Money Magazine) -- One of the reasons dividend investing has always been so appealing is that it never required much skill. All you had to do was go to the same spots visited by virtually every other income investor -- namely, the financial, health care, and industrial sectors -- and reel in blue-chip stocks sporting fat yields.

Yet in the wake of the financial crisis, one thing has become clear. Some of those traditional sources of dividends are no longer overflowing with income.

Take financials. Prior to the credit crisis, a number of giant banks were rewarding shareholders with $2 or more a share in dividends each year. Today some are paying less than a quarter a share -- if that. And it sure doesn't look as if those payouts will recover anytime soon.

So it's time to trawl for dividends in altogether different places. Whether you're a conservative investor who favors companies that give you a cut of the profits (because you don't think management knows how best to spend the money), or you're a retiree seeking to maximize yield and minimize risks, you'll want to diversify your sources of income.

Fortunately, these new sources of dividends will help you do that. They're also in a position to grow their payouts over time, reducing the chance that you'll fall short of your income needs down the road.

The first section of this story will help you invest in income-producing stocks in the simplest manner, through funds that specialize in dividend growth.

The rest of the sections will show you how to create a more customized -- and thoroughly diversified -- portfolio of dividend payers.

Why: History says firms that can raise payouts are a better buy in the long run than the highest yielders.

When fishing for dividends, you may be tempted to seek out stocks offering the fattest yields. Yet if the 2008 crash in financial stocks demonstrated anything, it's the risk of falling into a "dividend trap" -- where you buy a stock for its hefty yield right before the firm has to slash or eliminate the payments.

"We've seen how chasing yield is a dangerous proposition," says Don Kilbride, manager of the Vanguard Dividend Growth fund (VDIGX).

On the other hand, seeking out shares of companies that routinely bump up their payouts -- even if those dividends are modest at the moment -- can be exceedingly rewarding.

Analysts at Edward Jones studied the performance of stocks from 1972 through 2010. They found that when you factor in a stock's yield and changes in share price -- in other words, its total return -- the highest-yielding shares in the S&P 500 actually lost an average of 0.3% annually. By contrast, stocks that increased their dividends returned 9.6% on average during this stretch.

Of course, there are no guarantees that history will repeat. Still, "you can learn a lot about how the company is going to treat you in the future by looking at its dividend record," says Josh Peters, editor of the Morningstar DividendInvestor newsletter. Companies that consistently boost their payments are "telling you that the dividend is important to management and is something that they believe serves the shareholders well."

If you're living off the income your portfolio generates, it might seem hard to turn your back on a stock yielding 6% to go with one yielding half as much. Dividend growth, though, can close that gap fairly quickly.

Say you invested $100,000 in a stock yielding 3%. You'd earn $3,000 in income this year. But assuming that payout grew 15% annually, it would take only five years for your annual income to grow to $6,000. True, you'd have earned $6,000 right off the bat by going with a 6% yielder. But if the company was straining to meet those lofty payouts and was forced to cut its dividends, then where would you be?

Dividend growth can also help your income keep up with inflation, says Edward Jones strategist Kate Warne. She points out that since 1947, the rate of dividend growth has outpaced inflation by nearly two percentage points a year.

Where to invest:

SPDR S&P Dividend (SDY) (SDY) 3.1% yield; three-year annual return: 5.8%. This MONEY 70 fund sets the dividend growth bar high: It invests only in companies that have increased their dividends for 25 consecutive years. That makes for an exclusive club of 60 companies, including McDonald's (MCD, Fortune 500) and Exxon Mobil (XOM, Fortune 500).

Thornburg Investment Income Builder (TIBAX) (TIBAX) 5.6% yield, three-year annual return: 5.5%. Since Income Builder was launched in late 2002, the dividends it has produced have grown 11% annually. The fund takes a global approach, investing 49% of its assets overseas and holding 23% in bonds and cash.

Vanguard Dividend Appreciation (VIG) (VIG) 1.9% yield; three-year annual return: 4.2%. This ETF tracks stocks with at least a 10-year history of hiking payouts, such as Caterpillar (CAT, Fortune 500) and Coca-Cola (KO, Fortune 500).

Why: With tons of cash on hand, companies in even the fastest-growing sectors of the market are finding value in giving shareholders a cut of the profits.

In the past the best places to locate dividends were among a certain class of companies: humdrum businesses in plodding industries that needed to woo investors with the promise of recurring payments. They included shares of steady but slow-growing manufacturers, utilities, and banks. As recently as 2007, the financial sector paid nearly a third of all the dividends issued by firms in the S&P 500.

Today, dividends are no longer concentrated in one or two slices of the market. That's because banks were forced to cut their payouts and no longer dominate the dividend landscape.

Moreover, many fast-growing firms that used to shun dividends -- claiming investors were better served by having that money reinvested into the business to boost growth -- have become so big that their rate of expansion has slowed. As a result, they now need to start paying out cash to attract investors.

There's one more explanation: Corporations of all stripes simply have more dollars to hand back to their shareholders. Companies were forced to pay down debt and strengthen their balance sheets in the financial panic to avoid being locked out of the credit markets.

As a result, publicly traded firms are sitting on more than $1 trillion in cash. Now that the crisis is subsiding -- and profits are roaring again -- "they're becoming more willing to distribute that money," says Scott Davis, co-manager of Columbia Dividend Income.

So how should you expand your search? Start with fast-growing tech and consumer companies.

In the late '90s, tech would have been the last place to seek income, as the sector paid a mere 0.1%. Those yields have since climbed to 1%, and they have huge potential for growth.

The fact is, firms that pay out only a small percentage of their profits can afford to raise dividends in the future. Tech and retail stocks have, on average, payout ratios of 23% or less. The ratio for utilities, in contrast, is more than double that.

Where to invest:

Microsoft (MSFT, Fortune 500): 2.5% yield; three-year annual return: -1.2%. Its growth has slowed, but Microsoft still sits on more than $50 billion in cash -- enough to ensure dividend growth for years.

IBM (IBM, Fortune 500): 1.8% yield; three-year annual return: 13.7%. Big Blue has grown its dividend by 27% a year over the past five years. And the tech service provider -- which sits on $13 billion in cash -- should boost it by another 13% a year for the next three years.

VF Corp. (VFC, Fortune 500)2.5% yield; three-year annual return: 13.2%. The apparel maker, which owns brands like the North Face and Wrangler, is expected to grow its already above-average dividend by 6% a year over the next three years.

SIT Dividend Growth (SDVSX) 1% yield; three-year annual return: 4.4%. Most dividend funds shun fast-growing sectors. But Sit keeps 13% of its holdings in shares of technology companies, while many dividend funds keep less than half as much in that sector.

Why: Look beyond blue chips and you'll expand your universe of dividend growers by a third.

When blue-chip dividends were plentiful, conventional wisdom said, "Why even bother with smaller stocks?" As payouts have thinned out, conventional wisdom now says, "Why not?"

Plenty of small-company stocks have been issuing dividends for years. Of the 60 stocks that make up the S&P High-Yield Dividend Aristocrats list -- companies that have increased their payouts annually for at least a quarter of a century -- more than a third are shares of small or midsize firms.

Granted, smaller firms tend to pay less. The average yield on small- and mid-caps is about 0.6 point lower than for blue chips. But since these equities aren't thought of for their income, you may find some hidden gems, says Chuck Royce, president of the Royce Funds, which specializes in small stocks.

Where to invest:

FAM Equity Income: (FAMEX) 1.7% yield; three-year annual return: 3.3%. This fund has managed to boost its dividend payments by an average of 10% a year for the past five years.

Royce Total Return (RYTRX):1% yield; three-year annual return: 6.1%. Big yields aren't as important to this fund -- which owns 400 small-cap dividend payers -- as income-growth potential.

Why: Europe's economy may not be growing as fast as ours is. But the culture of paying shareholders first is much stronger there than in the U.S.

Your quest for dividend payers can no longer stop at our shores. These days, some of the heftiest payouts and fastest dividend growth are being delivered by companies abroad.

The average yield for blue-chip foreign companies in the developed markets of Europe and Asia now stands at more than 3% -- a full percentage point higher than the yield on the S&P 500. And big European stocks are expected to yield 3.8% this year.

Of course, you may be worried that these higher yields result from the recent underperformance of European stocks, thanks to that region's debt crisis. After all, a stock's yield often rises not because the company is becoming more generous, but because its share price is tumbling on fears over the issuer's financial health.

Dividend yields overseas, however, have outstripped those on U.S. shares by about one percentage point a year over the past decade -- a decade, by the way, in which European stocks far outshone domestic equities.

"There's a much stronger dividend culture abroad, particularly in Europe," says Judy Sarayan, a fund manager at Eaton Vance specializing in dividend stocks. "Individual investors play a larger role in those markets, and they have always demanded more dividends."

The good news: It's extremely easy to bet on income-producing foreign stocks these days through a slew of international dividend-oriented mutual and exchange-traded funds. What's more, by investing abroad, you'll benefit not only from the bigger payouts, but also from the weakening dollar, which serves to boost the gains that Americans enjoy on their overseas holdings.

Finally, in addition to the more generous current yields, dividends issued by foreign stocks have room to grow even higher. Citigroup analyst Adrian Cattley expects European dividend payments to increase by almost 10% in 2011 and 12% next year, as corporate earnings continue to rebound.

Where to invest:

Vodafone (VOD): 3.1% yield; three-year annual return: 1.4%. The world's second-largest wireless phone company has long been one of the most consistent dividend payers in telecom. And management has a stated goal of raising dividends by at least 7% annually through the end of its 2013 fiscal year.

Novartis (NVS): 3.4% yield; three-year annual return: 8.6%. Swiss-based Novartis has increased its dividend each year since its creation in 1996. Unlike many of its pharma rivals, which are facing the prospect of steep revenue declines as their drugs go off patient. Novartis has the wherewithal to continue making those hefty payments, analysts say.

SPDR S&P International Dividend (DWX): 4% yield; three-year annual return: 1%. This ETF tracks the S&P International Dividend Opportunities Index of 100 high-yielding mid- and large-cap global stocks. About 90% of the fund's holdings are in developed markets outside the U.S. Among its top holdings are France Telecom and Australian-based Westpac Banking Corp.

Why: Companies in fast-growing parts of Asia, Eastern Europe, and Latin America are starting to pay dividends to prove their worth to foreign investors.

When you think of ways to juice more income from your portfolio, betting on emerging-market stocks probably doesn't leap to mind. It's the spectacular growth in share prices -- and equally gut-wrenching declines -- you probably think of when it comes to investing in developing countries such as Brazil, China, India, and Russia.

Indeed, for the past decade dividends have contributed less than 18% of the total returns for emerging-market stocks, according to S&P international equity strategist Alec Young. By comparison, dividends have historically accounted for about 40% of the annual total return in the developed world.

As companies in these dynamic economies grow and inevitably slow, however, they're returning more cash to shareholders. In fact, the yield on the MSCI Emerging Markets Index is more than 2% -- higher than for the S&P 500.

Expect those dividends to keep on growing. Brazilian companies, for instance, are legally required to pay out at least 20% of their net profits. And as the rate of growth for companies in places like China goes from white-hot to simply sizzling, they're delivering heftier payouts to keep attracting foreign investors.

"These companies are issuing dividends to prove they're making real earnings and that there's no accounting manipulation going on," says Cliff Remily, co-manager of the Thornburg Investment Income Builder Fund. "You can't fudge cash dividends."

Where to invest:

Ambev (ABV): 4.5% yield; three-year annual return: 35.5%. The world's fourth-largest beermaker is required to pay out at least 35% of its net income. Merrill Lynch's Robert Ford expects the firm to exceed that and ABV's yield to hit 6% this year.

Taiwan Semiconductor Manufacturing (TSM): 2.8% yield; three-year annual return: 9.5%. The chipmaker has paid dividends since 1995. And as the economy recovers, the cash it generates should soon triple, "potentially setting up for a higher dividend payout," says Credit Suisse analyst Randy Abrams.

WisdomTree Emerging Markets Equity Income (DEM): 3.1% yield; three-year annual return: 10%. This ETF owns around 300 dividend payers in the developing world. More than two-thirds of those are blue chips. And a big chunk of assets are in more advanced economies such as Taiwan -- making for a less bumpy ride.

Why: Once you've settled on dividend growth, you still have to pick a strategy that fits your income needs.

The easiest way to invest for payouts is through a professionally managed mutual fund that specializes in dividend growth. Yet many of these portfolios invest mostly in shares of big U.S. companies.

Follow one of these two strategies to help you diversify and custom-tailor your portfolio of dividend-paying equities:

If you're still working: You have time to let your dividends gradually grow. Shoot for a well-diversified portfolio that yields around 2% to 3% now but through steady growth can boost that payout substantially over time.

If you're retired: You're probably looking to generate higher current yields -- say, from 3% to 3.5%. And you also want a safer ride. To accomplish both, reduce your exposure to small-company and emerging-markets stocks.

If you're waiting for giant banks and brokerages to recover -- and restore their dividends to pre-financial-crisis levels -- don't hold your breath. That could take years.

Sure, the financial crisis wiped out a large percentage of the dividends issued by banks and brokerages. With the economy on the rebound, though, you may be thinking that those payments are sure to bounce back in fairly short order, right?

Not so fast. The journey back to the good old days is going to be a tough slog, experts say. The financial sector, which once accounted for nearly a third of all S&P 500 dividends, contributes less than 12% today. That's because back in the darkest days of the economic crisis, government regulators forced banks to cut or suspend their dividends so they would preserve adequate levels of capital to stay afloat.

Fast-forward to March: The Federal Reserve finally allowed some large banks (with the notable exception of Bank of America) to start hiking their dividends. Yet those payments are still anemic. The overall dividend yield for the financial sector today stands at 1.5%, less than half the 3.3% yield it sported before the economic meltdown. Citigroup, for instance, recently said it would reinstate its dividend but at the equivalent of one-tenth of a penny per share.

Howard Silverblatt, S&P's senior index analyst, says you shouldn't expect bank dividends to return to their pre-crisis levels until at least 2014. The Fed may not allow banks to raise payouts much until their balance sheets improve significantly. Also, the number of shares issued by financial institutions has almost doubled since 2008, greatly depressing the dividend yield per share. Finally, don't forget that a slew of worries is still plaguing big banks, including bad loans, a weak housing market, and a flurry of new regulations, according to Goldman Sachs's chief U.S. equity strategist David Kostin.

Bottom line, says Silverblatt: "Dividend investing is still a time-honored strategy -- but the times are changing and you need to diversify your income portfolio."