ShareThisWith Federal Reserve chairman Ben Bernanke vowing to keep interest rates at record lows for at least two more years, more yield-starved investors are seeking refuge in the stocks of companies that pay regular dividends.
It's not hard to find stocks paying dividends that match or beat the current yield on the popular 10-year U.S. Treasuries, just under 2 percent as of last week. By comparison, the S&P 500 currently yields 2.2 percent.
But advisers warn that investors should not to be so tempted by fat yields that they overlook two fundamental questions: How safe is the dividend, and does the company have the ability and inclination to increase it in the future?
"Looking at pure yield is not going to give them all the information they need," said Tom Huber, who manages T. Rowe Price's $1.9 billion Dividend Growth Fund. "They need to understand if the dividend is sustainable at the current level and whether there's potential for dividend growth."
Yield is a measure of the income that a security pays, whether it's the interest on a bond or a dividend from a stock. It is determined by dividing the income a share of the security provides by the price an investor pays for that share.
The higher the price, the lower the yield -- and vice versa.
For example, as investors flocked to safe U.S. Treasuries in recent weeks, they paid increasingly more for the bonds, reducing the yield.
And as fearful investors sold stocks, they drove down stock prices, which increased yields for investors who purchased dividend-paying stocks at the depressed prices.
Price swings aside, a simple way to gauge a company's ability to pay a dividend is to compare its quarterly earnings to its quarterly dividend payments. A company earning 20 cents per share and paying a 25-cent dividend won't be in a long-term proposition unless it trims the dividend, eliminates it or increases earnings.
"You want to make sure there is plenty of net income to pay the required dividends," said Don Linzer, CEO of Schneider Downs Wealth Management, in Pittsburgh.
Linzer said companies with a track record of increasing dividends regularly might not offer the highest current yield, but could provide better returns over the long term as their earnings growth propels their stock price and dividends higher.
"You need to look at the total return," he said.
Keep in mind that the higher a claim dividends have on a company's earnings, the less cash remains to invest in new plants, new products, acquisitions or other earnings-boosting initiatives.
Fund managers who specialize in dividend stocks say a better measure of a company's ability to maintain and increase its dividend is its free cash flow, essentially the cash a company generates minus what it spends.
"I'm looking at free cash flow," said Daniel Peris, co-manager of Federated Investors' $3.2 billion Strategic Value Dividend Fund.
Peris also looks at a company's dividend history and gauges the willingness of a company to pay a dividend regularly and increase the payout over time.
As of July 31, the top five holdings in the fund he co-manages were: Verizon Communications, AT&T, Royal Dutch Shell (Class B), French oil and gas producer Total, and Vodafone Group, a mobile communications company.
Huber also likes telecommunication companies and utilities as well as consumer staples stocks that offer stable, consistent growth. As of July 31, his fund's top holdings were Accenture, a consulting firm; Chevron; Danaher, whose products include instruments and monitoring equipment; Exxon Mobil; and PepsiCo.
(Contact Len Boselovic at lboselovic(at)post-gazette.com.)
(Distributed by Scripps Howard News Service, www.scrippsnews.com.)
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