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 US Bancorp (NYSE: USB  ) and JPMorgan Chase (NYSE: JPM  ) .

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, such as Seagate Technologies and New York Times, 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 McDonald's (NYSE: MCD  ) and Yum! Brands (NYSE: YUM  ) 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 142 S&P 500 members with trailing dividend yields of more than 2.5% now, 73 of them (51%) have free cash flow payouts below 80%. Here are just a few of them:

Company

Dividend Yield
Oct. 28, 2007

Dividend Yield
Today

FCF
Payout Ratio

Windstream (NYSE: WIN  )

7.3%

10.1%

59%

PepsiCo (NYSE: PEP  )

2.1%

3%

59%

Tesoro (NYSE: TS  )

0.6%

2.5%

24%

Source: Capital IQ, a division of Standard & Poor's, as of Oct. 29, 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 owns no shares of any company mentioned. PepsiCo is a Motley Fool Income Investor recommendation. The Fool's disclosure policy once caught a fish "this big."


Read/Post Comments (4) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 01, 2009, at 10:21 AM, hrsdocs wrote:

    Yahoo finance key stats indicates WIN payout ratio is 120%, yet here you cite 59% in this article. Whats up with that?

  • Report this Comment On November 02, 2009, at 11:54 AM, geek6 wrote:

    NO! Please- Nobody believes the nonsense that Yahoo posts...

    They CANT pay out > 100%. Can you spend more than 100% of your free cash?

    Dividend money is like pension fund money, its a pot to tap when things get bad. Unfortunately for the poor fools who gave all their money to someone else (their employer) to hold while they themselves didnt manage it (my friend was laughing before the crash because we didn't, now hes not laughing, but crying over 6 figure losses...), the company is free to raid that fund, after all, who posesses it?

    Which is whats gonna happen to more fools investing in equities and commodities when said financially strapped companies need money. When one needs eggs, one raids the henhouse. Law of the jungle

  • Report this Comment On November 02, 2009, at 11:59 AM, geek6 wrote:

    Sorry, I should clarify. I hope everyone takes seriously the articles, charts etc that are LINKED on Yahoo, but please, dear God, dear Fools, don't believe anything, especially financial, posted on yahoo as "news" Yahoo is neither a news outlet nor a trustable financial source.

    My morning -with tea- laugh is the financial headline that may as well be computer generated:

    Stock market is <up, down> based on <insert last news headline to come in>

    Odd that the "stock market" is strictly the Dow Jones.

  • Report this Comment On December 26, 2009, at 9:43 PM, Fool wrote:

    TS is Tenaris S.A. not Tesoro...talking about Yahoo..

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