Now's the Time to Double Down on Dividends

Yes, you read that headline correctly. In the midst of the worst year for dividend investors in more than a generation, I'm telling you that now's the time to double down on dividend stocks. Allow me to explain.

A tough pill to swallow
While dividend payers have long been thought of as safe ports in stormy markets, this past year has been a notable exception.

Fully 62 of the S&P 500 companies cut their dividends in 2008, and even more cuts were announced in early 2009 by the likes of Weyerhaeuser and Pfizer (NYSE:PFE).

Financial blue chips like Bank of America that were thought by many to be defensive staples in dividend-based portfolios slashed dividends to the tune of $37 billion in 2008 alone. Other companies, like Whole Foods (NASDAQ:WFMI) and Freeport-McMoRan (NYSE:FCX), have opted to suspend their dividend payouts to shore up capital until things turn around.

With glum news like this, dividend-paying stocks look like more of a gamble than ever. But while no dividend -- or stock -- is 100% guaranteed, this particular stormy market is providing some great opportunities to buy strong, well-capitalized companies with high dividend yields -- at lower prices.

Here's how to find them
All dividend payers are not created equal, and you want to find the ones that have the businesses to back up those payments. Strong businesses will maintain or even increase dividends, even in a market like this one. Just look at Walgreen (NYSE:WAG) and General Mills as examples -- both announced dividend increases in 2009 while weaker names were cutting to shore up capital.

So how do you tell if a business is strong? Many people use the earnings payout ratio (dividends per share / earnings per share), but those numbers aren't always reliable because a company can strategically adjust net income for any number of reasons.

Rather, focus on the free cash flow payout ratio. It's much more difficult to fake the cash flow, and that means investors can have more confidence in it as a measure of dividend health.

Ideally, you want to find companies with free cash flow payout ratios below 80%, which demonstrates that the company has an adequate cash cushion to maintain its dividend payments -- and even raise them.

In fact, of the 142 S&P 500 members with trailing dividend yields of more than 3% now, 74 of them (52%) have free cash flow payouts below 80%. Here are just a few of them:

Source: Capital IQ, a division of Standard & Poor's, as of July 21, 2009.

Because of the market turmoil, you can find higher yields today than you could just a year ago; while their stock prices have declined, the companies' ability to pay dividends appears unchanged.

The combination of lower prices, higher yields, and a sustainable dividend is one you definitely want to research further.

But spread your bets
It's important to keep in mind that no individual company, however strong, is immune to the kind of sectorwide disaster that brought down the banks last year -- even after many of them had paid uninterrupted dividends for years. That's why diversification across sectors is so important, even if that means sacrificing a little yield.

This beaten-down market provides a great opportunity to build a high-yield portfolio made up of 10 to 15 stocks with well-protected dividends from different industries. With so many financially strong companies paying higher yields today, now's the time to double down on dividend stocks that have solid free cash flow coverage.

Good companies with well-covered dividend payouts are exactly what James Early looks for at our Motley Fool Income Investor service -- and the team is finding plenty. If you'd like to see what they're recommending now, consider a 30-day free trial. You'll also see all of the past recommendations and the best bets for new money now. Just click here to get started. There's no obligation to subscribe.

This article was first published Nov. 13, 2008. It has been updated.

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Todd Wenning loves the smell of dividends in the morning and does not own shares of any company mentioned. Whole Foods Market is a Motley Fool Stock Advisor recommendation. Paychex, Pfizer, and Waste Management are Inside Value choices. Paychex and Waste Management are Income Investor picks. The Fool's disclosure policy once caught a fish "this big."