The Potential Gains of Shrinking Dividends

Dividend cuts have resulted in the lowest payout in three generations. Companies are trying to preserve liquidity by holding cash, and reducing their payouts to shareholders. General Electric shrank its dividend by 68% in 2009. Dow Chemical also cut its dividend substantially, which it hasn’t done since it began paying one in 1912. According to a recent report in Forbes Magazine, 74 companies in the S&P 500 Index have cut $48 billion in dividends in 2009, the highest amount of all time. S&P analysts assert that dividend investors are going to feel the pain of this cut for a long time. They argue that “while stock prices can rebound quickly, companies are unlikely to increase dividends right away” when the economy finally shows signs of improvement.

Despite the downward spiral, some companies have shown that their payouts can survive and even thrive in the worst of markets. Analysts maintain that dividend investing is a smart route during volatile market fluctuations. A report by Ned Davis Research asserts that since 1972, companies that increase or pay dividends have returned 9.5% a year, beating the 6.8% average returns of the S&P 500. Historically, divided-paying stocks are a safe bet for uneasy investors, who could still count on a regular return for their investment.

The question is how to choose reliable income stocks. A consistent history of paying and increasing dividends is a sure sign of stability. Looking at the coverage ratio (earnings per share divided by the dividend per share) can also provide insight into the company’s sustainability. A ratio of two or higher means that the company has more than enough cash to pay its dividend. Even companies with lower coverage ratios can make steady payments as long as they have stable cash flows. Those that are able to raise their dividends during tough times may be setting themselves up for sizable outperformance.

Top fund managers and investors suggest investing in leaders like Abbot Laboratories (ABT) in pharmaceuticals and Verizon Communication (VZ) telecommunications. These are both growing industries that have only suffered minor setbacks in the recession and show signs of strong growth, particularly in emerging markets. Utilities and consumer stapes are particularly appealing because their dividends remain stable even if their stock prices decline. The Wall Street Journal cites AGL Resources (AGL) and NStar (NST) as reliable stocks that have a dividend yield over 5% and maintain strong balance sheets. Although many investors are losing money, those that can pick winners in tumultuous times will ultimately come out stronger.