Dividends: The Sweet Spot

Stocks offering healthy dividends can pay off in tough economic times. But be careful of high yields in the financial and utility sectors

by Ben Steverman

Even if stocks go nowhere this year—a distinct possibility as a recession looms—investors can get returns by hunting for companies that pay healthy dividends. You receive the company's quarterly payouts even if its stock, and the entire market, head south.

While this is a popular and often successful strategy during bear markets, it also entails some dangers. Watch out for stocks that offer an especially high dividend yield. That could signal that a company might not pay its dividend. For example, since the credit crisis began in July, financial firms have been disappointing investors by slashing dividends.

At the other end of the spectrum, profitable companies with airtight balance sheets often offer pitifully low dividend yields.

Good Bets

So where's the dividend sweet spot? We asked fund managers to name companies with healthy dividends but without too much risk, and where they're putting their money.

Some fund managers think that long-term investors can find some opportunities in the beaten-down financial sector. Dan Genter of RNC Genter Capital Management said his funds own U.S. Bancorp (USB), Wells Fargo (WFC), and Bank of America (BAC). He believes those big banks "are going to be the survivors" from the credit crisis, but their share prices could be in for a rough ride. If you can afford to wait out the crisis, the stocks' yields—5.5% for U.S. Bancorp, 4.4% for Wells Fargo, and 7% for BofA—can make waiting worthwhile over the next year or two, he says.

But you must tread carefully in the financial sector given the gloomy credit climate. "Land mines are very easy to find in the financial area," warned Kirk Mentzer, manager of the Huntington Dividend Capture Fund.

Some investors worry that financial firms are still paying out too much in dividends. Matt Kaufler of the Touchstone Value Opportunities Fund noted that Citigroup (C) offered a great yield last fall, but the bank soon had to cut its dividend and raise billions in extra capital. Now, with a dividend yield of more than 6%, Citigroup may need to do the same again if credit markets don't improve, some analysts warned.

Stock Staples

The other traditional dividend play is the safe, boring utility sector. Heavily regulated, utilities offer slow growth but high, consistent dividends. Kaufler owns Dayton Power and Light (DPL), with a dividend yield of 4.4%.

However, most managers warned of problems ahead for this sector. Utilities have already had a good run and many market observers think the stocks are overvalued. Many utilities will need to spend heavily on upgrading infrastructure, says Steve Neimeth, a portfolio manager at AIG SunAmerica. Also, they could face increased environmental regulation, especially if the next President tries to limit global warming.

A good place to find healthy dividend yields is the consumer staples sector, where products like food and tobacco provide steady cash even in recessions. Several managers mentioned Altria Group (MO), which offers a dividend yield of 4%. Altria is spinning off its international Phillip Morris businesses on Mar. 28.