Smart Dividend Plays in Tricky Times

Dick Dahlberg and Scott Davis of Columbia Dividend Income Fund have scored by focusing on companies with healthy cash flow. A current favorite: AT&T

When the market is topsy-turvy, it's worth making sure you have some cushions in your portfolio. Stocks that pay dividends provide not only extra bang for your buck, but they're also considered steadier and tend to outperform ones that don't. Two managers that hunt for companies with healthy free cash flow to pay dividends are Dick Dahlberg, 67, and Scott Davis, 50, skippers of the Columbia Dividend Income Fund (LBSAX). They hold companies that tend to have higher return on equity—a measure of how efficiently companies deploy their capital—and are less leveraged than the market. "These are companies that can sustain themselves," Dahlberg says.

Dahlberg observes that "we're very long in the tooth in the [economic] cycle," and they're seeing a lot of companies going from positive free cash flow to flat or negative free cash flow. "Companies have been investing their money in new products and that's coming at a higher cost," he says.

The Boston-based duo also considers valuation, using free cash flow yield (free cash flow from operations per share divided by the stock price). Their top holding (as of Jan. 31) is AT&T (T), followed by a raft of other blue chip names: Exxon Mobil (XOM), General Electric (GE), Pfizer (PFE), Verizon (VZ), Citigroup (C), Altria (MO), Lincoln National (LNC), McDonald's (MCD), and Chevron (CVX).

Clearly, they're doing something right. For the three-year period ended Jan. 31, Columbia Dividend Income Fund (A shares) had an average annualized total return of 13.6%, vs. a total return of 10.3% for the S&P 500 index (Standard & Poor's gives the fund its second-highest rank of 4 STARS). That also beat the 12.16% three-year return for large-cap value funds tracked by Morningstar. For the last year, the fund has risen nearly 19%, vs. a 16.13% average gain for its peers.

BusinessWeek.com's Karyn McCormack spoke with Dahlberg and Davis on Mar. 2 about the stock market and why investors should focus on free cash flow and dividends. Edited excerpts of their conversation follow.

What do you make of this week's wild ride?

Dahlberg: It's long overdue. Everybody had become too complacent.

Davis: What struck me the most was every Wall Street strategist was bullish. Everybody bought into the "Goldilocks" scenario (see BusinessWeek.com, 2/1/07, "The Fed: It's a Goldilocks Economy"). One of the surprises was reported earnings rose at a double-digit pace for so long, with fourth-quarter growth coming in above 10%, and I think there's a perception that that's the norm. It's partly about fundamentals and economics, but partly about investor perception—and I think that got ahead of itself.

Do you consider this a buying opportunity?

Dahlberg: Prices got well ahead of fundamentals. Prices have come down quite a bit to give some buying opportunities. But this is not a one-week phenomenon—it could take a while to shake out.

Davis: This has been a market where people have no respect for risk and they have not been compensated for taking risk. Now we're at the point where people are reassessing that.