Money Matters - Simplified

Now's the Time to Double Down on Dividends

 
Yes, you read that headline correctly. On the heels of the worst two years for dividend investors in more than a generation, I'm telling you that now's the time to double down on dividend stocks. Allow me to explain.

 

 A tough pill to swallow

While dividend payers have long been considered safe ports in stormy markets, this recession has been a notable exception.

In the S&P 500, 62 companies cut their dividends in 2008, followed by another 90 in 2009.

Financial blue chips like Bank of America, widely considered defensive staples in dividend-based portfolios, slashed dividends to the tune of $37 billion in 2008 alone. Other companies opted to suspend their dividend payouts to shore up capital until things turn around.

With glum news like this, dividend-paying stocks look like more of a gamble than ever. But while no dividend -- or stock -- is 100% guaranteed, this market is providing some great opportunities to buy strong, well-capitalized companies with high dividend yields -- at lower prices.

Here's how to find them
All dividend payers are not created equal. You want to find stocks with the financial strength to increase dividend payouts as the company grows, as Visa (NYSE: V) and Freeport-McMoRan (NYSE: FCX) did in October by 20% and 67%, respectively.

So how do you tell whether a dividend is sustainable and poised for growth? Many investors use the earnings payout ratio (dividends per share / earnings per share). However, those numbers aren't always reliable, because a company can strategically adjust net income for any number of reasons.

Instead, focus on the free cash flow payout ratio. It's much more difficult to fake the cash flow, which means that investors can have more confidence in it as a measure of dividend health.

Ideally, you want to find companies with free cash flow payout ratios of less than 80%, which demonstrates that the company has an adequate cash cushion to maintain its dividend payments -- and even raise them.

In fact, of the 137 S&P 500 members with current trailing dividend yields of more than 2.5%, a little more than half of them (75) have free cash flow payouts below 80%. Here are just a few:

Company

Dividend Yield

FCF Payout
Ratio

ExxonMobil (NYSE: XOM) 2.7% 64%
Home Depot (NYSE: HD) 3% 38%
Automatic Data Processing (NYSE: ADP) 3.1% 43%
PepsiCo (NYSE: PEP) 2.9% 53%
Colgate-Palmolive (NYSE: CL) 2.7% 39%

Source: Capital IQ, a division of Standard & Poor's, as of Nov. 2.

But spread your bets
It's important to keep in mind that no individual company, however strong, is immune to the kind of sectorwide disaster that brought down the banks -- even after many of them had paid uninterrupted dividends for years. That's why diversification across sectors is so important, even if it means sacrificing a little yield.

This still-beaten-down market provides a great opportunity to build a high-yield portfoliomade up of 10 to 15 stocks from different industries, each with a well-protected dividend. With so many financially strong companies paying higher yields today, now's the time to double down on dividend stocks that have solid free cash flow coverage.

© 2010 UCLICK L.L.C.