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 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 in a previous article, 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 that your yield is safe. In January, for instance, Dow Chemical (NYSE: DOW) was "yielding" about 11% when I noted, for a number of reasons, it might have to take a historic cut -- which it did two weeks later, to the tune of 64%. Based on analyst earnings expectations, Dow could be able to restore its previous payout within the next 2-3 years should it decide to do so.

How you should play it
Around the start of the current recession, our own dividend guru, Motley Fool Income Investor advisor 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. American Capital and Rio Tinto have had declining revenue over the past 12 months; they were vulnerable to a weak economy and capital markets, and a reduced demand for iron ore, respectively. And none of them 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: 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 has enough confidence in its ability to pay a dividend that it was willing to raise the payout.

Kraft and Procter & Gamble have fairly reliable and profitable consumer staples businesses. McDonald's is a cheap option that can become more relatively attractive during a weak economy. And they offer tasty yields to boot.

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'd like additional help choosing dividend dynamos today, I encourage you to take a peek at the stock James has just hand-picked for his Income Investor members by clicking here for a 30-day free trial.

Already a member of Income Investor? Log in at the top of this page.

This article was originally published Feb. 14, 2009. It has been updated.

Ilan Moscovitz doesn't own shares of any company mentioned. Procter & Gamble is a Motley Fool Income Investor pick. The Fool owns shares of Procter & Gamble. The Motley Fool has a disclosure policy.