Now's the Time to Double Down on Dividends

Yes, you read that headline correctly. On the heels 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 considered 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 have been announced in 2009 from the likes of Alcoa (NYSE: AA  ) and General Electric (NYSE: GE  ) .

Financial blue chips in particular, though widely considered defensive staples in dividend-based portfolios, slashed dividends to the tune of $37 billion in 2008 alone. Other companies, like DryShips (Nasdaq: DRYS  ) and Diana Shipping (NYSE: DSX  ) , 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 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. You want to find stocks with the businesses to back up their payouts. Strong businesses will maintain or even increase dividends, even in a market like this one. Just look at McDonalds and Lockheed Martin (NYSE: LMT  ) as examples -- both announced dividend increases in 2009 while weaker names were cutting to shore up capital.

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

Instead, focus on the free cash flow payout ratio. It's much more difficult to fake the cash flow, which means that 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 less than 80%, which demonstrates that the company has an adequate cash cushion to maintain its dividend payments -- and even raise them.

In fact, of the 118 S&P 500 members with trailing dividend yields of more than 3% now, 67 of them (57%) have free cash flow payouts below 80%. Here are just a few of them:

Company

Dividend Yield
Sept. 28, 2007

Dividend Yield
Today

FCF
Payout Ratio

Caterpillar (NYSE: CAT  )

1.8%

3.3%

44%

Altria (NYSE: MO  )

4.4%

7.8%

73%

Honeywell

1.7%

3.2%

31%

Source: Capital IQ, a division of Standard & Poor's, as of Aug. 26, 2009.

Because of the market turmoil, you can find higher yields today than you could just two years 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 from different industries, each with a well-protected dividend. 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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Fool analyst Todd Wenning loves the smell of dividends in the morning. He does not own shares of any company mentioned. The Fool's disclosure policy once caught a fish "this big."


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