The past year has been brutal for dividend-focused investors. Companies that not long ago were considered bastions of dividend fortitude -- Bank of America
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 their dividends, but there are plenty of stocks not only maintaining their dividends, but growing them -- 82 in January alone!
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 these three traits.
1. They 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 aristocrat Automatic Data Processing, for example, converts around 19% of its 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 major miners Freeport-McMoRan
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 caught my eye -- and that demonstrates these three qualities -- is Motley Fool Income Investor recommendation Republic Services, which recently saddled up with fellow trash giant Allied Waste to form the second-largest player in the trash game.
Trash and cash
Republic operates in a pretty mundane industry. But your trash is Republic's cash -- the company turns a stellar 10% of its revenue into free cash flow and pulls in operating profits about six times that of its interest expense. Even better, Republic's recently closed merger with Allied Waste should leave the combined company with even better results, thanks to scale, synergy through redundant routes, and increased pricing power. And as those of us who routinely lug our trash to the curb can attest, the company's core waste-hauling business is far from being cyclical.
Owning shares of Republic is a bit like a having a stake in a collection of small near-monopolies. Building a landfill requires a lot of cash, involves miles of red tape, and faces intense blowback from the locals. These challenges keep competition at bay and have helped lead to consolidation in the industry.
It gets better
For starters, there's no real chance that technological obsolescence will undercut Republic's service offering. Similarly, unlike Cisco Systems
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 localized pricing, as it often does in other industries -- picture local jewelers before Blue Nile.
Now, take the ability to set local prices with minimal competition, combine it with the rational pricing of this consolidating industry, and it's little wonder that Republic and the other major waste haulers are able to push around their customers. For its part, Republic has increased its prices 7% over the past year.
Dumping it all together
There's a lot to love about such sturdy, growing dividend payers -- just ask Republic's largest investor, Microsoft's Bill Gates. Republic 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 7.1%) has returned more than five 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.
Joe Magyer doesn't own shares of any companies mentioned in this article. Republic Services is an Income Investor recommendation. Microsoft is an Inside Value recommendations. Bank of America is a former Income Investor recommendation. There's nothing trashy about the Fool's disclosure policy.
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