Many like the idea of investing with the goal of producing income, or at least investing in less volatile, dividend-paying companies. After all, a common goal of virtually every investor is to one day go from supporting his portfolio to having that portfolio support him.

The income-investing strategy is a means to accomplish just that. Regardless of when you need the income, this strategy can help you choose a family of investments that will support you when the time comes. And keep in mind that this "time" doesn't have to be linked to a particular age. For many, it's simply when they decide that their portfolios should be able to pay the power bill in addition to financing their trips to Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) -- companies that both pay a dividend, by the way. Indeed, if you look ahead and begin building positions in dividend-paying companies, that time may come well before you expect it.

As much as investors tend to favor the dividend strategy, many aren't quite sure how to make it happen. Some ask, "What should I look at when evaluating these companies?" Or, "At what point does a high dividend yield become a bad thing?" Others ask, "How does researching income-producers differ from that of researching any other investment?" And finally, still others ask, "How could George Peppard have taken a role on The A-Team after having such a phenomenal career, including starring in the classic Breakfast at Tiffany's?"

I'll do my best to answer these questions (except for the last one, of course -- I'm just a man, after all) and give you a skill set that will allow you to beef up your yields while adding only quality companies to your portfolio.

What history tells us
I've mentioned this a few times before, so I won't give it much attention here, but history is definitely in the corner of the dividend payer when it comes to achieving market-beating performance with lower risk (in terms of volatility). Several studies have shown that dividend-paying companies tend to modestly outperform non-payers over long periods, including the 30 years from 1970 to 2000. But, perhaps more importantly, they've done it with about one-tenth the volatility of non-payers, so during all those years in between there was a greater chance that your money was there if you needed it. In addition, the dividend has accounted for 42% of the S&P 500's total return since 1926.

Too much of a good thing
One of the most challenging aspects of this strategy is figuring out how much is too much when it comes to a company paying out a dividend. To that end, the payout ratio is a very important consideration, but this statistic varies a great deal depending on the class of investment.

For instance, in order to maintain their tax-advantaged status, real estate investment trusts (REITs) are required to pay out 90% of their earnings in the form of dividends, so it isn't uncommon to see solid REITs that pay out as much as 85% of their funds from operations (FFO) or the cash flow that they generate from their real estate portfolios to shareholders. Such growth stocks as PepsiCo (NYSE:PEP), on the other hand, might pay out as little as 20% or 30% of their free cash flow (FCF) in dividends. Then there are the generous dividend payers in the banking and utility arenas, such as Synovus Financial (NYSE:SNV) and DTE Energy (NYSE:DTE), which often have a payout ratio in the 55% to 75% range.

So, as you can see, there's no magic number that's appropriate for all companies. But as a general rule, I would seek the following:

  • REITs with an FFO payout ratio below 85%
  • Higher growth common stocks that pay out less than 50% of FCF
  • Banks that pay out less than 70% of FCF
  • Utilities that pay out less than 80% of FCF

Other criteria to consider
Here are a few other criteria that we use as initial screens for Income Investor selections:

1. Show me the money. I've mentioned that cash doesn't lie. In other words, cash is real. It can't be faked (at least not without getting a visit from your local Secret Service agent). However, you have to take serious note of where the cash is coming from. In other words, is cash from operations currently covering the dividend, or is it being supplemented by cash on hand, or, worse, is the company borrowing to fund the dividend? Clearly, this is a big one to watch, because a dividend that's not being funded from operations is doomed to be cut.

2. Proven management team. Management is always a key consideration when choosing your investments, but I believe this is an especially important criterion to consider when evaluating dividend-paying companies. When operating a company that pays out a sizable portion of profits to shareholders in the form of dividends every single quarter, a manager must have a real gift for the efficient use of capital.

When a company pays a dividend, it leaves less cash on hand to grow and maintain the business. On the whole, I think this is a good thing -- I feel it motivates a company to be more selective with its projects and more efficient with its operations. However, a manager in this situation must have a great deal of foresight, being careful not to increase the dividend to the point where the company may not be able to grow or effectively compete in periods of challenging market conditions.

Look for experienced management that is well respected by co-workers, analysts, the media, and managers of other companies. You'd like to see someone who has been with the company for an extended period of time or, if new, someone who made a material contribution to the success of the company from which she came. A team of quality managers with a history of working well together is even more desirable. If you have a CEO, COO, and a chairman who have worked well together for several years, you're in a very positive situation.

3. A noticeable yield. Certainly not every company in this category has to yield over, say, 3% to be a solid income producer. However, choosing a company with a noticeable yield generally means you've got one that has made a commitment to its dividend. We want to see companies here that have a strong preference for generating shareholder value, particularly in the form of income, and a company with a payout that isn't just a token offering is one that has generally made a significant commitment to maintaining and growing its dividend.

4. Reliable dividend track record. Many of the companies selected in Income Investor have paid dividends for more than 30 years. Some have paid them for more than 50. That said, it's possible to find great values by being a contrarian investor, choosing firms that have suffered a fairly recent dividend cut. Make no mistake, this can be a much higher-risk approach than choosing a stable payer, but if you've got a situation where the cut is temporary, often the resulting price decrease can drive the company's yield higher than it was to begin with. Again, one must tread lightly here and have faith that the company is doing what's needed to ensure no further cuts are necessary, but it can sometimes prove a rewarding approach.

The Foolish bottom line
At the end of the day, this strategy is no different from any other in that it requires a significant amount of time and effort to succeed. One must dig through countless losers in order to find just a handful of the best opportunities, and if you simply don't have the time to make that commitment, or if you're looking to supplement your own selections, consider letting the Fool do the work for you.

This, after all, is my life's work, and professionally speaking, there's nothing I enjoy more. Income Investor provides two superior income-producing selections each month in addition to other actionable advice on how to increase yields in other areas of your portfolio. We also regularly feature other carefully screened selections, which, like the newsletter, are producing market-beating returns with lower volatility than the benchmarks.

Of course, we teach self-reliance here at the Fool as much today as ever, but if your personal schedule doesn't allow for this kind of research commitment, or if digging through hundreds of 10-Ks and 10-Qs isn't your idea of a hot Saturday night, we Foolish folk are happy to do it for you, because, well, that is our idea of a hot Saturday night.

This article has been updated since originally published on Nov. 1, 2003. Its heartfelt tale of "dividend love" is relevant now more than ever.

If you're interested in building a portfolio that runs on dividend power, consider a free trial to Motley Fool Income Investor . If you're not completely satisfied, we'll give you your money back -- guaranteed.

Mathew's last hot Saturday night occurred when his air conditioner quit during a summer heat wave. He owns shares of PepsiCo and Synovus Financial. The Motley Fool has a disclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.