Investor Alert

Weekend Investor

April 30, 2010, 8:28 p.m. EDT

The dividend strategies that best juice your returns

Get more for your money from companies that share the wealth

By Jonathan Burton, MarketWatch

SAN FRANCISCO (MarketWatch) -- Dividends are coming back in style with investors and they're not just for widows, orphans and coupon-clippers any more.

The tumultuous first quarter of 2009 was the darkest ever for dividends, with more companies slashing payouts than raising them. Dividend-paying stocks have also lagged their non-paying peers in the rally since March 2009.

Click to Play

Dialing into dividend growth

Cash-rich companies are increasingly sharing the wealth by giving stockholders larger dividends. Harry Domash, publisher of the Dividend Detective Web site, highlights several attractively valued stocks with equally attractive dividends that investors can consider now. He talks with Money & Investing editor Jonathan Burton.

Now dividend-paying stocks are being seen in a brighter light. U.S. companies are generally in much better financial shape due to sharp spending cuts in the recession and improving sales as the economy has recovered -- and management increasingly is choosing to share the wealth.

Paying it forward

So far this year, 98 companies in the Standard & Poor's 500-stock index (S&P:SPX) have boosted their quarterly dividend, including bellwethers Exxon Mobil Corp. (NYS:XOM) , International Business Machines (NYS:IBM) . Procter & Gamble Co. (NYS:PG) , and Johnson & Johnson (NYS:JNJ) .

In addition, seven S&P 500 companies have initiated a dividend in 2010, reflecting confidence in their future earnings ability, according to S&P. These include Carnival Corp. (NYS:CCL) , Marriott International Inc. (NAS:MAR) and Host Hotels & Resorts Inc. (NAS:HST) , and technology firms Tellabs Inc. and Broadcom Corp. .

The large-cap S&P 500 currently yields a bit shy of 2% annually, while dozens of well-regarded companies are even better income providers. The consumer and health-care sectors are particularly dividend-rich, as are the traditional sources utilities and telecommunications sectors. The notoriously stingy technology sector is being more generous with its cash; for example, shares of Microsoft Corp. (NAS:MSFT) yield about 1.7%; Oracle Corp. (NYS:ORCL) yields about 0.8%.

(Banks, of course, used to be reliable and substantial dividend producers, but the market's meltdown ended that. The financial sector's outlook is improving, but don't look for dividends to play a major role in the immediate future.)

Moreover, dividends have always reflected a significant part of stock investors' total return. That's especially appealing nowadays; after two crushing market meltdowns in less than a decade and a recent rise in market volatility, investors see dividends as steady cash givebacks they can count on every three months.

"The climate is very positive for dividend stocks," said Harry Domash, publisher of DividendDetective.com, a dividend-stock website. "A year or so ago it was about finding stocks that weren't going to cut their dividend and go out of business; now it's about finding high-yielding stocks in good sectors."

More than yield

Stock dividends in fact have become attractive bond alternatives, with their predictable and often higher income stream, plus the potential for price appreciation. But stocks typically are riskier than bonds and smart dividend investors know there's more to this strategy than simply buying the highest-yielding names -- tempting as that may be in today's low-yield environment.

A stock may have a fat yield because its business is in trouble. If a company's cash flow can't cover its dividend, that payout almost certainly will be on the chopping block -- with a corresponding hit to the shares. Sometimes the cash flow will be adequate but the business doesn't have terrific growth prospects; in that case you can expect income but not much in the way of capital gains.

Steer clear of these "dividend traps" by investing in companies that have regularly hiked their dividends year after year, preferably for decades. Look also at cash on the balance sheet, earnings-growth history and the quality of the business, all of which support a company's ability to keep increasing its payout.

"Focus on companies that are consistent growers and have strong competitive advantages," said Bob Millen, co-manager of the Jensen Portfolio (NAS:JENSX) . "Then you lessen the risk that you're going to get in the trap of buying a company that might cut its dividend." Millen follows that rule; Jensen has a strict policy of investing only in companies with return on equity of at least 15% for 10 consecutive years.

Such strong, disciplined approaches to dividend investing have the twin benefit of enhancing your portfolio's yield and controlling risk.

"A dividend is not going to make a bad business into a good stock," said Josh Peters, editor of Morningstar DividendInvestor, a newsletter from investment researcher Morningstar Inc.

"Management shares the growth of the business directly with shareholders through dividend increases," Peters added. "I would not consider buying any common stock that didn't have the capacity to grow its dividend, because it's a vital sign of financial health."

Dividend harvest

One ready supply of top-drawer dividend payers is S&P's "Dividend Aristocrats" -- a diverse group of larger companies that have increased dividends at least 25 years in a row. If a company misses one year, it's off the list.

This year's 43 Aristocrats include many household names such as McDonald's Corp. (NYS:MCD) , Coca-Cola Co. (NYS:KO) , PepsiCo (NAS:PEP) , Procter & Gamble, Kimberly-Clark Corp. (NYS:KMB) , Exxon Mobil, Johnson & Johnson, Target Corp. (NYS:TGT) , Wal-Mart Stores Inc. (NYS:WMT) and Walgreen Co.

Lesser-known Aristocrats include VF Corp. (NYS:VFC) , Consolidated Edison (NYS:ED) Inc., C.R. Bard Inc. , Automatic Data Processing Inc. (NAS:ADP) , Pitney Bowes Inc. (NYS:PBI) , Emerson Electric Co. (NYS:EMR) , Abbott Laboratories (NYS:ABT) and Eli Lilly & Co. (NYS:LLY) . Emerson, for example, has increased its dividend for 53 straight years.

Some firms not on the Aristocrats list but still garnering the high ratings from S&P include consumer-staples giants Colgate-Palmolive Co. (NYS:CL) , Kellogg Co. (NYS:K) and J.M. Smucker Co. (NYS:SJM)

Predictability is important for dividend investors, who tend to be a patient lot and often buy more shares through company-sponsored dividend reinvestment plans, commonly known as DRIPs.

"Dividend investors typically invest for years or decades," wrote Howard Silverblatt, senior index analyst at S&P, in a recent research note. "Investors need to be comfortable with the company's long-term business model."

If researching individual U.S. stocks is too daunting, dozens of mutual funds and exchange-traded funds offer dividend-centric portfolios. Yet finding the right dividend investment isn't solely about yield and return; you also have to incorporate two key factors that are in your control -- risk and cost.

Using a screen developed by Christine Benz, Morningstar's director of personal finance, Morningstar searched for diversified U.S. stock funds that sport 12-month trailing yields of 2% or better, with below category-average risk and expenses.

The results produced 18 retail funds with five-year returns. The top five on that score: Vanguard Equity-Income (NAS:VEIPX) ; Vanguard Dividend Growth (NAS:VDIGX) ; American Funds American Mutual (NAS:AMRMX) ; ING Corporate Leaders Trust Series B (NAS:LEXCX) and State Farm Growth (NAS:STFGX) .

A companion search produced exchange-traded funds for dividend-oriented investors to consider. The highest-ranked on a yield basis include: iShares Dow Jones Select Dividend Index (NAS:DVY) ; WisdomTree SmallCap Dividend (PSE:DES) ; SPDR S&P Dividend (PSE:SDY) (a portfolio based on the Dividend Aristocrats); Vanguard High Dividend Yield Index ETF (PSE:VYM) , and WisdomTree MidCap Dividend (PSE:DON) .

Other ETFs worth noting: First Trust Value Line Dividend Index (PSE:FVD) ; PowerShares Dynamic Large Cap Value (PSE:PWV) ; Vanguard Value ETF (PSE:VTV) , and SPDR Dow Jones Industrial Average (PSE:DIA) , dubbed the Dow "Diamonds" in reference to its ticker symbol, which tracks the 30-stock benchmark (DOW:DJIA) .

The Dow, in fact, is a wellspring for dividend-based investment strategies. One of the most popular, the so-called "Dogs of the Dow," invests in the 10 highest-yielding components in a given year, such as current leaders Verizon Communications Inc. (NYS:VZ) , AT&T Inc. (NYS:T) , and Merck & Co. (NYS:MRK)

Tax watch

No discussion of dividends can ignore the possibility that the favorable tax treatment of dividends will end this year. The Obama administration has proposed a 20% tax rate on stock dividends, versus the 15% rate most taxpayers pay now. But without congressional action qualified dividends will be taxed at full individual income-tax rates starting in 2011.

If Congress does not act, many companies might decide to prepay fourth-quarter dividends in 2010 rather than early next year, or even to use surplus cash for a special dividend.

In anticipation of such an outcome, equity strategists at Bank of America Merrill Lynch recently screened for nonfinancial companies they believe stand a good chance of providing such a one-time payout -- particularly where managers and other insiders have significant shareholdings and so would be adversely affected by a tax-law change.

Candidates include Microsoft, Gap Inc. (NYS:GPS) , Estee Lauder Cos. (NYS:EL) , Polo Ralph Lauren Corp. (NYS:RL) , and CA Inc. . The list even includes companies that have never paid a dividend, such as eBay Inc. (NAS:EBAY) and Dell Inc. (NYS:DELL)

Still, as with other aspects of investing, taxes shouldn't be your most important concern.

"Prior to the 2003 Tax Act, dividends had always been taxed at ordinary tax rates and dividend-paying stocks still outperformed non-dividend-paying stocks," Morningstar's Peters said. "Dividends aren't about having some tax dodge; it's about earning a more reliable return from stocks than from capital gains alone."

Link to MarketWatch's Slice.