2009: Will It Be the Worst Year Since 1958?

According to a study by Ned Davis Research, in the 34 years between 1972 and 2006 (a period with both surges and plunges in the stock market), dividend-paying stocks outperformed non-payers handily, averaging 10% vs. 4% annually. Take a moment to appreciate that difference:

• Invest $10,000 for 34 years at 4%, and it will grow to $38,000.
• Invest $10,000 for 34 years at 10%, and it will grow to $255,000.

Looking back even further, my colleague Shannon Zimmerman explained in The Secret of Dividends, "Between January 1926 and December 2006, 41% of the S&P 500's total return was due not to the price appreciation of the stocks in the index, but to the dividends its companies paid out."

That's the good news: Dividends are powerful, and they can be a critical part of your long-term get-rich plan.

Now for the bad news
These days, dividends are drying up. In fact, they're drying up at a rate we haven't seen in 50 years! (See what my colleague Tim Beyers has to say about that.)

At the end of January, Howard Silverblatt, senior index analyst at Standard & Poor's, told the Associated Press that "it is easy to say this is going to be the worst [dividend-cutting year] in 50 years, but the bigger question is whether it is going to be much worse than that."

Last year, 62 S&P 500 companies cut their dividend payouts by nearly $41 billion. Already, the dividend cuts in 2009 have exceeded those of 2008!

Here are a few recent cuts:

• Bank of America cut its annual dividend from $1.28 per year to $0.04, a 97% trim.
• Newell Rubbermaid cut its dividend 50%.
• Pfizer (NYSE:PFE) cut its dividend 50%.

All is not lost
This is enough to have us rethinking any commitment to dividends we might have had, right? Well, it shouldn't -- things are not as dire as they may seem. There are plenty of companies not cutting their dividends, and plenty of companies raising them. According to Jack Hough in SmartMoney magazine, "For each S&P 500 company that cut payments [in 2008], six increased them."

For example, the following firms have been hiking their dividends:

• McDonald's (NYSE:MCD) upped its dividend by 33% last fall.
• PepsiCo (NYSE:PEP) hiked its dividend by 13% in June 2008.
• Norfolk Southern (NYSE:NSC) increased its dividend by 6% in January 2009, on top of a 10% increase last year.
• Wal-Mart (NYSE:WMT) upped its dividend by 15% earlier this month.

What to do
Fortunately, dividend cuts are rarely surprises. You can see many of them coming -- as shareholders of Bank of America and some of the other big banks surely did.

For starters, the best place to look is at a firm's payout ratio, which is the percentage of net income it pays out to shareholders as a dividend. For a basic example, let's assume Company A has an annual dividend per share of $1.28. Over the past 12 months, its earnings per share were $3.07. Divide $1.28 by $3.07 and you'll get 0.42 -- or a payout ratio of 42%.

When you screen for dividend-paying candidates for your portfolio, keep a close eye on the payout ratio. If it's steep -- approaching or certainly surpassing 100% -- dig deeper to see what's going on. That's not very sustainable. I prefer to see the ratio around 50% or below.

To get you going with a few stock ideas, I screened for companies with reasonable payout ratios:

Source: Yahoo! Finance. Data as of March 10, 2009.

It can also be useful to compare a company's payout ratio with its historical average to see if it's been rising or falling.

We'd love to introduce you to many promising dividend payers via our Income Investor service, which you can try for free. On average, its picks are beating the market handily and boast an average dividend yield of more than7%! Click here to learn more.

Things to remember
Finally, know that companies never take dividend-cutting lightly. Many have been hiking them regularly for decades and they don't want to break that streak. Even without a streak to protect, they know that investors will be alarmed and worried upon news of a cut.

Still, cutting can make sense, if it permits a company to survive or thrive. Just as we need to park our dollars where they'll do the most for us, so do companies. In the case of Pfizer, if it thinks it can get more ultimate value for its shareholders by paring back its dividend payouts and redeploying that money into its Wyeth acquisition or some other project, then that can make sense.

So, don't write off dividends -- just proceed sensibly, and reap those profits!

Longtime Fool contributor Selena Maranjian owns shares of PepsiCo, Wal-Mart, 3M, and McDonald's. PepsiCo is a Motley Fool Income Investor recommendation; Pfizer is a former pick. 3M, Pfizer, and Wal-Mart are Motley Fool Inside Value picks. Aflac is a Motley Fool Stock Advisor pick. The Motley Fool is Fools writing for Fools.