As the bear market savaged energy stocks last summer, Vic Dura spied an opportunity. After examining many companies' prospects, along with their price-earnings ratios, he came up with a half-dozen possibilities. He looked closer and crossed Noble Drilling and Cooper Cameron off his list. Why? Neither pays a dividend. "Companies can play around with earnings and estimates, but they can't play around with a dividend. Either they paid it or they didn't," says Dura, an engineer in Rogersville, Ala., who works for telecom-gear maker TXPORT. In the end, Dura settled on oil-services giant Halliburton and Diamond Offshore Drilling, yielding 1.8% and 2.3%, respectively.
Dura is pursuing a strategy used by market pros impressed that dividends, over the long run, have provided over 40% of the total return on equities. By buying stocks that pay out part of their earnings as dividends, they're building portfolios that are relatively high on return and low on risk.
FOCUS ON FEAR. Right now, dividend-paying stocks figure to get increasing attention as investors, eager to preserve capital, focus more on fear than greed. "In a recessionary environment, a higher-yielding stock approach is a good one," says T. Rowe Price Dividend Growth Fund manager William Stromberg, who notes that zippier, but riskier, growth stocks often pay no dividend. Joseph Lisanti, the author with Joseph Tigue of The Dividend Rich Investor (McGraw-Hill, $14.95), adds that dividend hikes accelerate during bear markets. "Management wants you to hold on to your shares," he says. "They don't want selling pressure."
There's no shortage of dividend-paying stocks, of course. On the New York Stock Exchange, more than half of the 2,905 common issues offer dividends. But remember that a dividend can be cut--a move that almost always sends the stock price tumbling. The best strategy, Stromberg suggests, is the simplest: "Find proven companies. Buy them when they are temporarily out of favor, then forget you own them."
Some out-of-favor companies got that way because they're truly in trouble. One way to winnow out the losers is to follow the strategies of Anthony Spare, a manager of more than $1.5 billion at San Francisco's Spare, Kaplan, Bischel & Associates. Spare, the author of Relative Dividend Yield (John Wiley & Sons, $49.95), says he first limits his search to companies with market values of at least $1 billion, since larger companies tend to be more stable. Next, he focuses on stocks yielding more than the market overall--now about 1.6% for the Standard & Poor's 500-stock index--and more than they have historically. Higher relative dividend yields imply lower relative share prices, a disarmingly easy way of finding potentially undervalued stocks. With the market way off its high, there are plenty more of those now than there were in June.
The process has led Spare to take big positions in such companies as gte, J.C. Penney, and Eastman Chemical. More recently, he has been attracted to 3M, which pays annual dividends of $2.20 a share. With 3m selling at $75 a share, that's a yield of over 2.9%--far higher than the market overall and a bit more than the company's average yield of 2.8% over the past five years. "Is the company in good shape?" asks Spare. "Yeah, it's the same company it has always been. Has the stock been neglected? Yeah."
With these broad guidelines in mind, we went looking for dividend-paying stocks that might prove to be good investments. Using StockQuest software, available free at Market Guide's Web site (www.marketguide.com), we screened the database of 9,216 companies for U.S. stocks with prices of at least $5 a share, market values of at least $1 billion, and average annual dividend growth of at least 5%.
We set a minimum of 3.2% for yields and an arbitrary maximum of 4.5%. That kept the list to a manageable size and knocked out most utilities and real estate companies, traditionally high-yielding groups that otherwise might have dominated the list. Finally, we excluded any stocks without at least 20% ownership by officers, directors, and other insiders on the theory that they're less likely to cut an income stream they benefit from directly.
The result? A list of 20 companies, which we then trimmed for a variety of reasons. Chrysler made the first cut, but it's about to merge with Daimler Benz, and its future dividend yield has not been set. Companies, such as health-care products maker Mallinckrodt, that recently posted net losses got the ax. Finally, we checked to see whether each stock's yield was higher than its average for the past five years. While many Web sites and such print resources as Value Line Investment Survey provide a stock's year-by-year yield history, you can save time by plucking the five-year average yield from the free "Corporate Profile" section of Telescan's Wall Street City site, www.wallstreetcity.com.
Among the dozen survivors are a pair of paper makers, Consolidated Papers and Westvaco; a few banking companies, TCF Financial and People's Bank; an insurer, Unitrin; a real estate developer, Rouse; an energy company, Kerr-McGee; copper miner Phelps Dodge, and four manufacturers: Allegheny Teledyne, Cummins Engine, Hercules, and International Flavors & Fragrances (table). There's no way of knowing whether all are winners, but the list makes a good field for further prospecting.
Spare suggests looking carefully at the strength of the company's cash flow--that, after all, is the source of dividend payments--and its "dividend coverage." That's the ratio of cash earnings left after a company meets all other obligations to the total amount a company pays out in dividends. The higher, the better. Anything under one you should see as a warning sign.
Even if a company's financial picture has dimmed, you shouldn't exclude it immediately. "We know stocks are most attractive when there is some deterioration occurring" on the balance sheet, Spare says. You should be able to diversify away the risk of a company cutting its dividend by investing across different industries but buying shares in no more than, say, two dozen companies.
If you're not prepared to do the research yourself, use the challenge of finding good dividend-paying stocks as a way to test a full-service broker. Describe the kind of stocks you're looking for--those with market values of $5 billion or more, say, and yields at least 50% above their historic average--and see what kind of list that generates. Then make the broker defend the safety of the stocks' payouts to win your orders.
Another way to invest in dividend-paying stocks is through a mutual fund. Among several recommended by Lisanti and Tigue are Tri-Continental, a large closed-end fund yielding 2.2%; aarp Growth & Income, which in the past year yielded 2.2%; Lexington Corporate Leaders (4.4%), and T. Rowe Price Dividend Growth (2.4%). All have lost less than the S&P 500 since its July peak. For the T. Rowe Price fund, Stromberg says he has been buying shares in banking company First Union, which recently yielded 3.8%, and British conglomerate Tomkins, at over 5%. People who are looking for a "high-beta, jackrabbit approach" to investing should steer clear of his fund, Stromberg says. "This is the tortoise strategy"--one that offers protection at times when you feel like pulling in your head and taking cover.