The Next 3 Dividend Dynamos

Pop quiz: Which major event helped some investors to quadruple their returns over the 25 years from 1929 to 1954? Ding ding ding! You guessed it: the Great Depression.

Wait, huh?
Data from renowned dividend scholar Jeremy Siegel shows that although it took 25 years for the S&P 500 to return to its 1929 levels, those who reinvested their dividends earned a total return of 334%. How did that happen?

As Siegel explains, dividends are "bear market protectors and return accelerators," because falling stock prices lead to higher dividend yields ... and higher dividend yields allow for reinvested dividends to accumulate tons of new shares at lower prices.

And that isn't the only time dividend stocks have boosted returns for investors during bear markets.

For instance ...
When I ran the numbers over the 2000-2002 bear market, I found that dividend-paying stocks outperformed non-dividend-paying stocks by an incredible 47 percentage points on average. Granted, that particular time frame is known for the bursting of the dot-com bubble, when many non-dividend-paying tech companies crashed and burned. But over longer periods, the thesis holds.

In fact, according to research from professors Kathleen Fuller and Michael Goldstein, from 1970 to 2000, dividend-paying stocks outperformed non-dividend payers during down markets by an average of 1.5% per month!

But simply picking the highest-yielding stocks is not a recipe for success. As I've noted previously, high yields often signal danger, and when blowups do occur, the fallout isn't pretty: Companies that cut their dividends in 2008 fell by 57% on average for the year.

So it's critical to make sure your yield is safe. In January, for instance, Dow Chemical was "yielding" about 11% when I noted, for a number of reasons, that it might have to take a historic cut. That's exactly what it did two weeks later, to the tune of 64%.

How you should play it
Around the start of the current recession, our own dividend guru, James Early, revealed his basic three-part screen for how to get started researching dividend stocks in a bear market.

I was curious to see how well James' strategy works, so I conducted a study using data from the previous recession -- which, according to the National Bureau of Economic Research, began in March 2001.

The results were impressive: Stocks with James' criteria that were bought at the beginning of the recession and held for five years -- what I deem a reasonable holding period -- would have netted investors 122% on average, versus just 12% for the S&P 500!

So what were his criteria? James insisted on stocks that had:

• Yields greater than 3%
• Dividends that had been increased over the previous 12 months
• Growing revenue

Here's a sampling of some of the stocks that fit those specifications back in 2001:

Data from Capital IQ, a division of Standard & Poor's.

Of course, times change, and none of these stocks would pass the test today. Although it had a strong third quarter, American Capital has had declining revenue over the past 12 months on lower interest and income on its investments. The company hasn't paid a dividend since last year. US Bank yields just 0.8% now, after its dividend was trimmed during the financial crisis. And none of these three companies has grown its dividend over the past year.

Why it works
Generally speaking, companies won't cut their dividend right after they've raised it, so a dividend increase during a recession is an especially strong sign that you can trust a tasty yield.

Unfortunately, there are some less savory reasons why management would raise a dividend during difficult times, such as a myopic desire to provide stock-price support, an inability to anticipate market conditions, or general incompetence.

Growing revenue is one objective sign that your investment candidates are improving their economic performance, even in the face of a tough market -- a difficult hurdle to clear. More recently, insisting on growing revenue in addition to growing payouts would have helped investors avoid disappointments such as Huntington Bancshares, which raised its dividend in 2007 amid declining revenue -- and has since had to take massive cuts.

Drumroll, please ...
So which three dividend dynamos might help you to take advantage of rising yields today? Of the companies that match James' strategy, I chose three for you.

To review, each of these stocks has:

• A greater-than-3% yield
• A recent dividend increase
• Growing revenue

In addition, I wanted to make sure these stocks have less than 80% free cash flow-payout ratios. Here are the results:

Source: Capital IQ, a division of Standard & Poor's.
*Net income payout ratio.

Despite the recent economic downturn, each of these companies has managed to expand its business, and each has enough confidence in its ability to pay a dividend that it was willing to raise the payout.

They operate in fairly downturn-resistance industries -- pharma, utilities, and food distribution, respectively. Bristol-Myers Squibb makes a number of drugs that many consumers will continue to purchase regardless of economic conditions. Electricity and food are two necessities that cost-conscious consumers are less likely to stop buying.

Even more ideas
While studies such as Siegel's and Fuller and Goldstein's, as well as my own research, prove that dividend investing is an excellent strategy in down markets, the increased possibility of dividend reductions means you need to be extra-selective in your investments.

If you're looking to incorporate more dividend stock ideas into your portfolio, enter your email in the box below to get "Motley Fool Top Picks & Perspectives 2011," a new free report with stock recommendations and portfolio guidance for the year ahead. We'll also tell you more about Million Dollar Portfolio, our real-money portfolio service that buys the best of our investing ideas, opening for the last time this year. To get started, just enter your email in the box below.