Finding Stable Dividends in a Rough Market

If you are a dividend investor, you may feel like you're sailing into a stiff wind. But by setting your course carefully, you can find reliable dividend income that will keep your portfolio cruising.

Just don't expect the calmest seas ahead. Companies in Standard & Poor's 500-stock index, which have produced four consecutive years of record dividend payments, are beginning to sharply curtail dividend growth. Meanwhile, the strong U.S. dollar is dragging down the results of many multinational companies favored by dividend investors. Another threat to dividend payers looms with rising interest rates, which can lure conservative investors out of stocks and into bonds. Perhaps most painfully, the oil-price plunge has pummeled the energy sector, which accounts for more than 10% of S&P 500 dividends, and prompted some high-profile dividend cuts.

Some older dividend investors are calling it quits. Since retiring in 2009, 64-year-old Lee Schmidt has held dividend payers ranging from consumer-products giants to real estate investment trusts and master limited partnerships, which transport and store oil and other natural resources. But he grew increasingly uneasy last year as the market gyrated, major dividend cuts made headlines and some of his energy-related holdings fell off a cliff. By the end of the year, he had sold almost all of his dividend stocks. "I've been really hurt," says Schmidt, a retired sales and marketing manager in Chicago. Now, he's relying on corporate bonds for income. "I am really just trying to stay out of anything that can possibly cause trouble," he says.

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Yet this may be precisely the wrong time to dump high-quality dividend-paying stocks. While some dividend payers -- most notably those in the energy sector -- have suffered, well-diversified funds holding companies with strong balance sheets and a history of growing dividends have actually offered investors much-needed shelter in this market storm. The blue-chip-focused Vanguard Dividend Growth Fund, for example, lost 3.7% in the 12 months ending in mid February, while the S&P 500 dropped nearly 9%.

And with bank accounts and high-quality bonds still offering paltry yields, most retirees can't afford to ignore the income that's available in stocks. The S&P 500's 2.4% yield may not sound like much, but it looks generous compared with the 1.7% yield of the 10-year Treasury. "Very few people can live off of 2%," says Charles Farrell, chief executive officer at Northstar Investment Advisors in Denver. Most investors need the combination of price appreciation and dividends available in stocks "to make the numbers work in retirement," he says.

Investors who have grown accustomed to the brisk dividend increases of recent years will have to reset their expectations. In the fourth quarter of 2015, U.S. stocks' dividend net increases (that's dividend hikes minus dividend cuts) amounted to $3.6 billion, a sharp slowdown from the $12 billion net increase in the fourth quarter of 2014, according to S&P Dow Jones Indices. With corporate profits sagging and a slow economic recovery, the dividend deceleration is expected to continue this year -- and it's already expanding beyond the energy sector. Fertilizer giant Potash Corp. of Saskatchewan, Canada, for example, in January cut its dividend for the first time in the company's history.

In a world of slowing dividend growth and potentially rising rates, your dividend-investing strategy may need some tweaks. If you've been focused purely on dividend growth -- buying low-yielding stocks or funds with strong potential to boost payouts -- you may be setting yourself up for disappointment. If dividend growth decelerates, "now you don't have much of a yield to fall back on," says Josh Peters, director of equity income strategy at investment-research firm Morningstar. "Those stocks are not really going to distinguish themselves in terms of income performance."

If you've been focusing on the highest-yielding stocks you can find, you may also want to adjust your strategy. Higher-yielding stocks may be hurt more when interest rates rise, as conservative investors dump these riskier holdings to take advantage of higher yields in the bond market.

The solution: Stake out the middle ground. High-quality stocks with moderately high yields of roughly 3% to 5% and meaningful growth rates should hold up relatively well even if dividend growth slows and rates rise, advisers say.

Finding Dependable Payers

Dividend cuts can rob retirees of money they were counting on to cover living expenses, and they have a depressing effect on stock prices. Looking at rolling 12-month periods between 1972 and the end of last year, Ned Davis Research found that S&P 500 stocks cutting or eliminating dividends produced an average annual 0.8% loss, compared with a 7.2% average gain for steady dividend payers and a 9.8% gain for stocks that increased or initiated dividends. Stocks that offered no payout at all fared better than the dividend cutters, delivering a 2.5% return.

To reduce your risk of suffering dividend cuts, first look at the yield of any stock you're considering buying. A sky-high yield can be a warning sign. "If you see something with an 8, 9, 10% yield, very rarely is that going to be a screaming bargain," Peters says. Most of the time, "it's a dividend that's in imminent jeopardy of being cut."

Also be wary of stocks with a high yield relative to their industry peers. For example, "even a 5% yield might be too high for packaged food companies," Peters says. These stocks typically yield 2% or 3%.

Use Web sites such as Morningstar.com or Yahoo Finance to check out a company's financial strength and dividend history. Farrell looks for companies with low debt and "a consistent pattern of dividend growth that roughly tracks the company's long-term earnings growth." That suggests the company is committed to returning cash to shareholders but isn't paying out more than it can afford.

Playing Dividend Defense

Amid all the volatility, where can you find steady dividend payers that offer meaningful income and good growth potential? Many money managers and analysts point to some of the market's most defensive sectors -- utilities and consumer staples.

Utilities have a reputation for offering very little growth. But that's changing, Peters says, as many utilities invest huge sums in improving reliability, connecting renewable energy sources to the grid and installing "smart meters" that help improve tracking of energy use. The result: "What you have across wide swaths of the utility industry is some of the best earnings growth trajectories that you've had maybe in decades," he says. "I'd rather own those names in a slow-growing economy than a lot of other stocks."

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Peters' favorites include Duke Energy (symbol DUK) and American Electric Power (AEP). Duke is the U.S.'s largest utility, serving more than 7 million electric customers in North Carolina, South Carolina, Indiana, Ohio, Kentucky and Florida. The company has been modernizing its generation facilities and grid and investing in wind and solar projects -- and Duke has paid a quarterly dividend for 90 years. American Electric Power, which serves about 5.4 million customers in 11 states, is investing in major transmission projects. It has paid dividends for more than 100 years.

The strong U.S. dollar has weighed on consumer staples, because many of these companies generate a sizable chunk of their sales overseas. While currency fluctuations cause short-term bumps, their effect tends to be "neutral over the long term," says Daniel Peris, manager of the Federated Strategic Value Dividend Fund. As of December, the fund devoted more than one-third of assets to consumer staples.

Some consumer-staples giants that are currently in turnaround mode can offer investors attractive income along with growth potential. Procter & Gamble (PG), maker of Tide laundry detergent and Bounty paper towels, has struggled in its attempts to enter new emerging markets and is now selling off many of its brands and cutting costs. "They're on the path to recovery," says Phillip Davidson, who holds the stock in his American Century Equity Income Fund. Investors who have grown tired of waiting for the turnaround, he says, "are missing an opportunity to own a high-quality company and get paid while you wait."

Davidson also likes General Mills (GIS), maker of Cheerios and Progresso soup. The company is shedding some older brands and investing in growth areas such as organic and natural products.

Real Estate and Other Promising Sectors

Some investors are wary of real estate investment trusts in an era of rising rates, which tend to depress property values and boost REIT borrowing costs. But REITs have posted positive returns in four of the six periods since the early 1970s when the 10-year Treasury yield rose significantly, according to Standard & Poor's. And in half of those periods, REITs beat the S&P 500.

REITs are actually "in a sweet spot here," says Sandy Pomeroy, co-manager of the Neuberger Berman Equity Income Fund, which devotes about 20% of assets to REITs. "Ever since the financial crisis, there's been a lot of reluctance on the part of real estate developers to add new supply," she says. Solid demand, combined with limited supply, look positive for REITs, she says.

One of Pomeroy's REIT holdings is Crown Castle International (CCI), which owns cell towers and rents out space on those towers to major wireless carriers such as Verizon and Sprint. Crown Castle has long-term contracts with its customers, and ever-growing cellular data traffic gives the company great growth potential. The company aims to grow its dividend by 6% to 7% annually.

Peters also sees strong growth ahead for health care REITs -- particularly Ventas (VTR) and Welltower (HCN). These REITs own senior housing, skilled-nursing facilities, hospital properties and medical office buildings. "These are very economically resilient," Peters says. "The demand and need for health care services is there, whether we're in an economic boom or a recession." What's more, he says, the aging population gives these REITs "a really good long-term demographic tailwind."

Some money managers are also sifting through the financial sector for dividend payers that can benefit from rising rates. Pomeroy points to MetLife (MET). Ultra-low rates have been a big negative for the life insurer in recent years, depressing returns on MetLife's large investment portfolio. The company "has suffered greatly from a low-interest-rate environment, but in a rising-rate environment, their earning power goes up a lot," Pomeroy says.

Does turmoil in the energy sector present opportunity for dividend investors? Some managers are watching the sector carefully for opportunities to pick up energy giants on the cheap. The Federated Strategic Value Dividend Fund, for example, added Exxon Mobil to its portfolio last fall when it was yielding more than 4%. But generally, "we've been trimming energy over the last 16 months," Peris says.

While the shadow of potential dividend cuts hangs over much of the energy sector, investors can still find reliable and attractive dividends in carefully selected master limited partnerships. For more on MLPs, see Income Flows from Energy Partnerships.

Diversifying With Funds

Dividend-focused mutual funds and exchange-traded funds let you scoop up a broad basket of dividend payers. Pay attention to fund fees, which take a bite directly out of the income you'll receive. You'll also need to understand whether the fund pursues a dividend-growth strategy (which may give you a lower yield), a high-dividend-yield strategy (which can mean higher interest-rate risk) or some combination of the two.

The Vanguard Dividend Growth Fund (VDIGX), for example, seeks out companies that are committed to growing their dividends over time. The fund, which is a member of the Kiplinger 25, has a stellar long-term track record, beating 98% of competitors in the large-cap blend category over the past 10 years, according to Morningstar. And it charges fees of just 0.32%. But with its focus on dividend growth rather than current yield, the fund's yield is just 1.9% -- less than the S&P 500.

Tony Welch, ETF strategist at Ned Davis Research, likes ETFs focusing on high-quality stocks that can deliver a blend of dividend growth and attractive income. He points to Schwab US Dividend Equity ETF (SCHD), which offers a 3% yield and charges rock-bottom fees of 0.07%. The fund tracks an index that selects stocks based on cash flow to total debt, return on equity, dividend yield and dividend growth rate. "That gives you a mix of dividend growth and dividend yield, and the fund tends to hold up better when rates are rising," Welch says.

Another high-quality dividend ETF that Welch likes is Vanguard Dividend Appreciation (VIG), which yields 2.4% and charges fees of 0.10%. The exchange-traded fund tracks an index of stocks that have boosted dividends for at least 10 consecutive years.