Dividends Still Make Sense for Investors

It's tough to find a financial advisor or a mutual fund manager who would deny the attractiveness of a fat dividend-paying stock. After all, studies have shown that stocks that make these periodic payments perform better over the long term than those that don't. Dividends can also protect a portfolio from the impact of inflation and they can provide much-needed income during retirement. That all sounds good to us.

However, 2008 has been anything but kind to investors who follow a dividend-focused strategy. These payments were some of the first things cut by struggling financial companies looking to shore up their ailing balance sheets. (Standard & Poor's says dividend cuts increased almost ninefold in September from the same time period last year.) That's been a reminder to thousands of investors that dividends don't carry a guarantee, especially those that thought they were being conservative by investing in neighborhood banks engulfed in the credit crisis.

"The ultimate irony is that retired investors who had a big percentage of their holdings in banks for that dividend are the ones who have been hit the hardest," says Eric Thorne, an investment advisor with Bryn Mawr Trust Wealth Management outside Philadelphia. "Those institutions were considered safe."

In addition, as share prices across the board have been battered, many investors are salivating over risky stocks that all of the sudden sport dividend yields that easily outpace the S&P 500. Needless to say, jumping into those stocks is a potential recipe for disaster.

Given all that, we thought it was a perfect time to revisit this topic. While the experts we talked to this week aren't giving up on the investing thesis behind dividends -- indeed, we found just the opposite -- they also aren't solely focusing on these payments as an ultimate stock-picking criterion. In fact, they are re-doubling their research efforts to make sure a given company will actually be able to make these payments over the long haul. It's a smart strategy that any diversified portfolio focused on dividend-paying stocks, mutual funds and ETFs can easily duplicate -- even when the market looks like it's imploding.

In order to comprehend the power of a dividend payment we feel compelled to first explain what they are. A dividend payment is a distribution of a portion of a company's earnings to its shareholders. The board has the discretion to pay one, increase it or cut it altogether. In some cases a company will make these payments when it can't find a suitable reason to inject the cash back into the business. In other situations, some stodgy industries like utilities use these payments as a way to attract investors. The payments are usually listed in a per-share amount. A dividend yield -- the measurement many fund managers use when picking stocks -- is calculated by taking that per-share payment and dividing it by the current share price. So a $50 stock that pays a $2.50 dividend would sport a 5% yield.

A healthy dividend yield will typically be somewhere near the current yield of the S&P 500 index or the rate of inflation (both of which are hovering around 3% right now). Of course, there are hundreds of stocks that feature yields of 10% or more. And therein lies the trouble, especially this year.

The higher the dividend yield a stock posts the riskier it is. Before investing in a high-yielding stock, smart investors check the company's cash flows to make sure it will be able to sustain the payments -- and hopefully grow them -- over the next few years. If there is any uncertainty, a double-digit yield instantly becomes worthless. We've heard stories about investors who chase yield and they usually never end on positively.

This year the economic downturn has complicated things. For example, if the hypothetical $50 stock we mentioned above was cut in half, say to $25 per share, and the company continued to pay the same dividend amount, the yield would jump to 10%. That looks sweet. However, you have to ask yourself if the stock was indiscriminately cut in half or if there was justification for that fall. The financial sector has traditionally been a big source of dividends. Would you be willing to pump your hard-earned money into a bank right now just because of a 10% yield? We wouldn't move in so blindly.

"[Over the last year] you could have invested in the world's largest, most attractive companies and you still would have gotten hit," says Bernie McGinn, founder of McGinn Investment Management in Alexandria, Va. "There were companies with fortress-like balance sheets that two weeks later were gone."

Financial advisors usually suggest shooting for a portfolio that yields the same as, or 1.5 times the rate of, the S&P 500. We think that's a smart strategy, especially if it's attained using a wide array of investing products. But remember these same advisors are doing homework on valuations, as well, and a company that buys back its shares with cash that could have gone to a dividend payment could be a decent investment, too.

There are essentially three options for building a dividend-focused portfolio, or at least one that has a healthy yield: individual shares, mutual funds and exchange-traded funds. If you fancy yourself a stock picker focus on your favorite company's ability to pay the dividend in the future (and, as we mentioned earlier, grow it, too). PowerShares has several ETFs with a dividend focus. Dividend Achievers (PFM) tracks an index of companies that has consistently increased their dividends for 10 or more consecutive years. PowerShares High Yield Equity Dividend Achievers (PEY) is a sister ETF that invests in the 50 highest-yielding stocks in a similar index. IShares Dow Jones Select Dividend fund (DVY) is also in this space. Each fund, though, tracks indexes that are heavily weighted toward financials.

One way to stick with a dividend strategy and avoid a large helping of financials is to search for an actively managed equity income fund. (Equity income funds typically favor dividends.) The 1st Source Monogram Income Equity fund (FMIEX) is one of the best and has an impeccable track record.