The Best Undercover Dividends

Like Iron Man, dividends are a force to be reckoned with.

If you ask me, there is no better way to quickly determine the overall attractiveness of a stock than by checking out its dividend. Dividends can give you a sense of whether a company is really making money, whether its stock is reasonably valued, and how management views shareholders. All in all, it's a pretty mighty number.

And while most investors are very familiar with dividend royalty -- that is, a company like ExxonMobil (NYSE: XOM), which is huge and dependable and has grown its dividend payout at a 5.7% annual rate over the past 27 years -- there are also plenty of good dividend-paying companies that are small enough to fly under Wall Street's radar. And many of these undercover dividend payers offer higher dividend payouts, better growth, or both.

To uncover some of these small dividend dynamos, I turned to the Motley Fool CAPS community, looking specifically for companies with a market cap below $5 billion and a dividend yield above 2.5%.

Source: CAPS and Yahoo! Finance.

Judging from their star ratings, the CAPS community doesn't have a high opinion of all of these dividend payers. Let's take a closer look to see if any of these dividends are truly mighty.

The rest
With just a two-star rating, it's obvious that CAPS members have serious reservations about Foot Locker. While the current dividend seems fairly safe thanks to the company's healthy cash flow, investors may be concerned about the company’s potential to grow its bottom line and enable future dividend growth.

You often hear people in the entertainment industry say that content is king, and I wonder whether we could say something similar about the footwear industry. Nike (NYSE: NKE), whose products play a prominent role in Foot Locker's business, has seen its revenue climb 36% since its 2005 fiscal year, while margins have held fairly steady. Foot Locker, meanwhile, has watched its revenue slide 9%, while its operating margin has fallen from 7.4% in 2005 to 2.5% over the past 12 months.

Foot Locker has laid out an ambitious plan to turn its fortunes around, but a lot will depend on how well that plan is executed.

Blackstone's three-star rating isn't terribly compelling. And for dividend-focused investors, the low rating makes particular sense.

When Blackstone first hit the public markets, it pledged that, until December 2009, the public unit-holders would be paid out first, until they had received $1.20 in distributions. We're past that point, and now the company's dividend policy doesn't really commit it to a set payout. Rather, the payout is determined by the company's distributable cash flow and how much the company decides to retain.

For hardcore dividend investors, a decreased payout is like a slap to the face. For investors in Apollo Investment, it's been a really hard slap. After paying out $2.07 in its fiscal year ended March 31, 2008, the company paid just $1.08 in the 12 months ended last December.

But it's not just the lowered payout that makes me inclined to disagree with the five-star rating from CAPS members, it's also the potential bankruptcy from Apollo investment Innkeepers USA. Apollo made a massive bet on Innkeepers and it's obviously gone terribly wrong.

So far Apollo has written down its combined $263 million investment in common and preferred equity in Innkeepers to just about $84 million, so the additional impact of any bankruptcy wouldn't be that large. However, a writedown of that size does have to make you wonder about the company's investment process.

As much as I hate to go against the CAPS consensus, I'm going to do it again with Navios. I need to be clear here, though: I don't necessarily have a bad outlook on the company in general, but as a dividend investment it's not one that I'd put at the top of my list.

The company, which came public in 2005, has only been paying dividends since 2006, and that short history already includes a cut. Also, the company's shipping business suggests a future laden with debt and rife with big swings in the business as the economy has its ups and downs. So while Navios could be a good investment, it may well leave dividend lovers with a bit less hair.

The best
Now that I've dismissed our other contenders, I would like to say that I'm extremely stoked about Otter Tail. Unfortunately, I have reservations about the company at the moment.

The fact that Otter Tail hasn't raised its dividend since 2008 is a particular disappointment because the electric utility had such a fine track record of annually growing its payout.

But it makes sense that management kept the payout steady. In 2008, the company's payout ratio -- dividends as a percentage of earnings -- was 108% and it climbed to 165% in 2009. That's dangerous territory, and if things don't start turning around soon, the company could have to make some tough decisions about that dividend.

But there's a reason I still think Otter Tail is the best of the bunch. The company is very committed to its dividend and has a dividend record that stretches back to 1938. And it's looking like the picture for this utility-anchored conglomerate is on the upswing.

Though first-quarter revenue was still down from the prior year, operating income jumped 86%. At the midpoint of management's current 2010 guidance, Otter Tail would deliver $1.20 in earnings per share, which would bring the payout ratio back down to a still worrisome, but not as terrible, level of around 100%.

The stock changes hands at 17 times analysts' expected 2010 earnings, which isn't cheap, but isn't overly expensive either. What's nice for dividend investors, though, is that the current yield on Otter Tail is an attractive 5.9%.

Your turn
Think any of these dividend payers have what it takes to be top-notch investments? Head over to CAPS and share your thoughts on the prospects for Otter Tail or any of the other companies listed above.

Not convinced that you need to own dividend stocks? Try this on for size.