You Should Buy Stocks Just Like This One

The past year has been brutal for dividend-focused investors. Companies that not long ago were considered rock-solid dividend plays -- see The New York Times, General Electric (NYSE: GE  ) , Weyerhaeuser (NYSE: WY  ) , etc. -- are slashing payouts left and right. More companies cut their dividends in the first half of last year than in all of 2006 through 2008 combined.

There's plenty of reason to be sore about those dividend cuts: Mind-blowingly thorough research from Wharton professor Jeremy Siegel shows that dividends are a crucial driver of long-term market outperformance.

But rather than spend the rest of this recession hiding under a rock, we dividend-loving investors can profit. Yes, many companies are cutting them, but there are plenty of companies not only maintaining their dividends, but growing them.

Spotting the long-haul winners 
As we've seen, cuts happen. But fortunately, identifying dividend payers with sustainable, growing payouts isn't exactly rocket science. You just need to know what you're looking for. Companies with long, uninterrupted histories of dishing out dividends typically share the following three traits.

1. They consistently rake in cash. 
Healthy dividends are funded with free cash flow, which means that prodigious cash generation and dividend safety go hand in hand. Dividend-dealer and payroll kingpin Automatic Data Processing  (NYSE: ADP  ) , for example, converts more than 15% of revenue into free cash.

2. They aren't cyclical. 
During boom times, profits in a cyclical industry flow like a Saudi oil well, often leading management teams to overcommit to high dividends and significant expansion. Picture construction- and industrial-driven plays, miners, dry bulk shippers, and homebuilders, among others.

When a cyclical industry tightens up (and such industries always do), cash profits follow suit, and once-high dividend payouts quickly find themselves on the chopping block.

3. They are conservatively capitalized. 
Even well-run companies that aren't in cyclical industries can occasionally find themselves on the outs. Look for companies that consistently produce operating profits well in excess of their debt obligations. By looking out for companies that demonstrate these qualities, you're setting yourself up to find the next great dividend winner.

A company that recently boosted its dividend -- and that demonstrates these three qualities -- is Motley Fool Income Investor recommendation Waste Management, the largest player in the trash game.

Trash and cash 
Waste Management operates in a pretty mundane industry. But your trash is Waste Management's cash. The company turns a solid 9% of its revenue into free cash flow and pulls in operating profits more than four times the size of its interest expense.

And while declines in industrial trash collection have slowed growth, those of us who routinely lug our trash to the curb can attest that demand for residential trash collection is extremely consistent.

Owning shares of Waste Management is a bit like having a stake in a collection of small near-monopolies. Building a landfill requires a lot of cash, involves miles of red tape, and incites intense blowback from the locals. These challenges keep competition at bay and have helped lead to consolidation and better pricing in the industry.

It gets better 
For starters, there's no real chance that technological obsolescence will undercut Waste Management's service offering. In other words, Waste Management won't play the role of Intuit’s  (Nasdaq: INTU  )  Web-based TurboTax to anyone's classic H&R Block  (NYSE: HRB  )  model. Barring the advent of beam-me-up-Scotty technology, there are no paradigm shifts on the landfill horizon.

Another plus: Unlike an Intel (Nasdaq: INTC  )  or a Novartis (NYSE:  NVS  ) , Waste Management doesn't have to spend gobs of cash on research and development every year to maintain its competitive position. Waste hauling is as static a business as it is boring -- and that's a good thing.

And unlike with oil, gasoline, and other high-value-to-weight commodities, it doesn't make economic sense to haul trash over long distances. That means you don't have to worry about distant competition threatening your relatively captive customer base, as it often does in other industries -- picture your local jewelry store pre-Blue Nile.

Dumping it all together 
There's a lot to love about such sturdy, growing dividend payers -- just ask one of Waste Management's largest investors, Bill Gates. Waste Management is typical of most Income Investor recommendations: strong, well-managed, and boasting healthy cash flows and a sustainable dividend.

On the surface, there isn't much pizzazz to dividend-focused investing, but as Jeremy Siegel's research and Income Investor's results have shown, the strategy is a proven winner.

Since the newsletter's inception in 2003, the average recommendation (which currently yields 4.3%) has returned seven percentage points more than the S&P 500. Subscribers receive fresh stock ideas each month, access to all past recommendations, and the team's top six recommendations for new money now. You can try the service free for 30 days with no obligation to subscribe. Click here to get started.

This article was first published Aug. 29, 2008. It has been updated.

Fool senior analyst Joe Magyer owns shares of Waste Management, which is an Income Investor and an Inside Value recommendation. Intel is also an Inside Value recommendation. Blue Nile is a Rule Breakers pick. Novartis is a Global Gains recommendation. Motley Fool Options has recommended buying calls on Intel. There's nothing trashy about the Fool's disclosure policy.


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