Bet on dividend-paying stocks

By Jim Jubak

Climbing odds of a recession. Slowing earnings growth. Rising inflation. Rising interest rates. Falling dollars. And, yes, even falling interest rates.

The list of things for investors to worry about is getting rather lengthy. And navigating a portfolio through a long list of worries is extremely tricky.

If the economy slips into recession, it would increase the odds of interest-rate cuts and lessen the danger of inflation. However, inflation is ticking up as global energy prices, a major source of inflation, continue climbing even while the U.S. economy is slowing.

Persistent inflation would make interest-rate cuts less likely and might even lead to rate increases. Slowing earnings growth would be bad for stock prices, but if that worry proved groundless, any investor who sold stocks could be left to play catch-up.

What to do? What to do? Try my portfolio of Dividend Stocks for Income Investors.

At times like this, dividends are king. Stocks paying a high yield will hold up better as the market goes south. If interest rates go down, the prices on these stocks will go up because high yields will attract yield-hungry buyers. If recession fears turn out to be overblown, these stocks will go up along with the market. If inflation strikes, companies will see revenue and earnings increase, and they'll be able to raise dividends, making dividend-paying stocks a better bet than bonds.

Stocks paying a high dividend aren't a perfect investment. Nothing ever is. If the stock market goes down hard, these stocks will suffer, too, although an investor will still collect that dividend while waiting for the stock to recover. If the stock market soars, these stocks won't climb as fast as pure growth or momentum stocks, I grant you.

An appealing refuge

Still, they're a good bet in a difficult market that seems more volatile every day. With the Dow Jones Industrial Average ($INDU) up 200 points one day and down 200 the next, income stocks are an appealing refuge. That's one reason my portfolio shows an average annual return of 10.3% since I started it Oct. 14, 2005. That's a very good absolute return for an income portfolio. In contrast, such well-managed bond market mutual funds as Fidelity Total Bond (FTBFX) and Vanguard Institutional Total Bond Index (VITBX) have returned an average annualized 4.3% and 5.2%, respectively, for the period. It's especially good if you remember that the initial goal was simply to beat what was then a roughly 5% yield on Treasury notes.

And it's a pretty good relative return, too. That 10.3% annual return for my income portfolio compares to an average annual return of 11.8% during that period for the Standard & Poor's 500 Index ($INX) and an annualized 16.2% for the Dow. It's tough for a low-risk income portfolio to match the gains in an equity portfolio when the stock market is climbing, as it has been for most of the period since October 2005. Such a portfolio should really shine, however, if stocks go into a retreat or get choppy.

But that's all past performance -- which, as they say, isn't indicative of future returns. So where do we go from here?

That's a tough one. Some income sectors, such as utilities, have been bid up so high that today's yields have become minuscule. Florida utility and wind power leader FPL Group (FPL, news, msgs), for example, is up in price by 70% from Oct. 14, 2005, to Dec. 13, 2007. And the dividend yield is down to 2.34% even though the company has raised its dividend payout twice during that period.

Investors must be selective

And finding high-dividend stocks for which the dividend is going to stay high has become a challenge recently. The debt-market crisis has led to dividend cuts at financial companies such as Freddie Mac (FRE, news, msgs) and talk of dividend cuts at Citigroup (C, news, msgs). I don't think we've seen the end of dividend cuts either, as banks stressed by the crisis decide to conserve capital by cutting the payout to shareholders.

While you're studying dividend yields, don't forget about the share price. If the U.S. economy does slow in 2008, as many expect it will, you don't want to be holding shares that are sensitive to an economic downturn. A slide in share price can take the shine off a high-dividend yield pretty quickly.

In other words, buyers looking for income stocks now need to be both selective and opportunistic.

Continued: What to look for

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