Stocks that pay you to own them

By Harry Domash

Editor's note: To view the stock screen mentioned in this column, download the free MSN Money Investment Toolbox.

The market's somersaults have inspired many investors to consider dividend-paying stocks, a category formerly considered suitable only for widows and orphans.

The advantage of dividend stocks is that you don't have to wait until you can sell them to make money. Dividend stocks actually pay you to own them. If the share price moves up while you own them, so much the better. Let's start at the beginning.

About dividends

Dividends, in this context, are regular cash payments that you receive, typically quarterly, based on the number of shares you own (not one-time payments or stock dividends used to implement stock splits).

Dividend payers have potential advantages over other stocks, especially now. If you pick the right stocks, even in a down market, you're still collecting the dividend, so you get paid to wait out the downdraft. Also, if the stock drops, the dividend yield to new investors rises, attracting more buyers. Here's how the math works:

The dividend yield is the next 12 months' expected per-share dividends divided by the current share price. For example, the yield would be 5% for a stock currently trading at $100 per share that is expected to pay $5 in dividends over the next year ($5 divided by $100).

If a market downdraft hits and the share price drops to $75 per share, the yield would increase to 6.7% ($5 divided by $75) to new buyers.

Dividend ups and downs

In good times, most companies increase their dividends from time to time, usually at least once a year. However, in times like these, some companies will cut their payouts to conserve cash.

When the dividend goes up, you can win two ways: The higher payouts increase your yield, and the dividend increase usually drives the share price higher. Alas, a dividend drop cuts your yield and usually pressures the share price.

Normally, your broker adds any dividends that you receive to your cash account. However, many brokers also offer automatic reinvestment plans. With these plans, your dividends are used to purchase additional shares, even if the dividend equates to only a fraction of a share. Thus, by reinvesting your dividends, you are receiving dividends on your dividends, compounding your returns.

Safe and sane

Here's a screen for finding relatively safe dividend-paying stocks. The operative word here is "safe." Rather than going for beaten-down stocks paying huge dividend yields, we'll look for strong companies operating mostly in recession-resistant industries that, we hope, will be the strongest players when the economy recovers.

In normal markets, dividend yields typically range from less than 1% up to 6% or 7% for "in favor" stocks. Stocks seen as especially risky sometimes pay as high as 10% or 11%.

But this market is far from normal. Today, with share prices smashed by fears of a 1930s-style depression, many apparently solid stocks are paying double-digit yields. While those yields are tempting, they reflect concerns that dividend cuts are on the way. Whether or not those concerns are well-founded, the high yields equate to high risk.

For the screen, I set my minimum acceptable dividend yield at 3.75%, better than most bank certificate-of-deposit rates. On the high end, I set my maximum at 8%. Try reducing your minimum acceptable yield to 3.5% if you want to see more stocks. Cut the maximum allowable yield to 6% or 7% if you want to further reduce your risk. Don't even think of raising that limit.

Screening parameter: Current Dividend Yield >= 3.75

Screening parameter: Current Dividend Yield <= 8.0

Low debt

With the availability of corporate credit iffy at best, it's tempting to avoid companies carrying any debt at all. But most long-established companies do carry some debt. Thus, a no-debt requirement would limit your selection mostly to the tech sector. You don't want to put all your eggs in that basket, especially in this market.

It makes more sense to consider entire industries when evaluating debt. Stocks in industries with predictable and steady revenue streams, such as utilities, can safely carry more debt than companies with unpredictable cash flows, such as retail stores or cell phone makers.

The debt-to-equity ratio, the most commonly used debt measure, compares total debt with shareholders' equity. The higher the ratio, the higher the debt. I use the D/E ratio to compare stocks with their industries and require ratios no higher than 75% of the industry average. Try moving that figure down to, say, 50% if you want to reduce your risk.

Screening parameter: Debt to Equity Ratio <= 0.75* Industry Average Debt to Equity Ratio

Continued: Profitable 2 ways

 1 | 2 | next >