Go the distance - Dividends for the long run

This is shaping up as the worst year for dividend cuts in three generations. Striving to conserve cash amid the most severe slump since the Depression, companies are reducing or eliminating their payouts to shareholders.

Banks, of course, have led the way, but also cutting payouts are such stalwarts as Dow Chemical (DOW, Fortune 500) (which hadn't cut its dividend since it began paying one in 1912!), General Electric (GE, Fortune 500), and Pfizer (PFE, Fortune 500).

In all, 74 companies in the S&P 500 index have cut $48 billion in dividends in 2009 -- the highest amount ever -- and Standard & Poor's senior index analyst Howard Silverblatt forecasts average payouts to fall by 36% from last year. That would be the worst annual percentage decline since 1938.
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But dividends are not dead. Some companies maintained or raised them in the past year, indicating that their payouts can survive even the worst markets. And dividend investing remains a sound course amid market turmoil. Ned Davis Research shows that since 1972, companies that increase or begin paying dividends have returned 9.5% a year, soundly beating the 6.8% return of the S&P 500.

So how do you find income stocks you can count on? Ideally you want established companies that have a long history of dividend increases.

You also want to look at the coverage ratio -- earnings per share divided by the dividend per share. A figure of two or higher tells you the company has plenty of money to pay its dividend. (Companies with lower coverage ratios can also be steady payers if they have stable cash flows.)

To help you identify reliable choices, we asked three top-rated fund managers who specialize in dividend stocks for their best ideas -- and did a little screening of our own.

We started with Rick Helm, manager of Cohen & Steers' Dividend Value fund, which has outperformed its average competitor by 2.5 percentage points annually since its 2005 launch. Helm recommends Abbott Laboratories (ABT, Fortune 500), now yielding 3.1%. The $30 billion pharmaceutical giant, known for its rheumatoid arthritis drug Humira, has hiked its annual payouts for more than three decades.

Helm believes that no matter what happens with health-care reform, Abbott will thrive thanks to its diversified businesses in drugs, diagnostics, and nutritional drinks. He expects the stock, which trades at 14 times next year's estimated earnings, to appreciate smartly.

Roger Sit, chief investment officer of Sit Investment Associates, whose Dividend Growth fund has beaten the S&P by 4.9 percentage points a year since 2004, looks for companies with sustainable business models that dominate their industries.

For example, Verizon Communications (VZ, Fortune 500), yielding 6.3%, is his top telecom holding. Sit notes that Verizon boasts the widest margins in wireless of any carrier and has almost completed building its FiOS high-speed Internet network, a massive project that cost $15 billion over five years.

Verizon's dividend coverage ratio is below one right now, but Sit analyst Joseph Eshoo considers Verizon's dividend to be safe and expects the coverage ratio to improve as spending on the FiOS network winds down. Eshoo prefers Verizon to rival AT&T (T, Fortune 500), which offers a similar yield, because of Verizon's superior mobile network.

Thomas Cameron, chairman of money-management firm Dividend Growth Advisors, has been preaching the value of dividends for 40 years. His Rising Dividend fund's 3.7% annual return since 2004 has beaten the S&P 500 by nearly 3% a year.

Cameron likes Magellan Midstream Partners (MMP), a $1.2 billion master limited partnership, or MLP, that runs more than 9,400 miles of oil pipeline in the U.S.? He suggests buying MLPs such as Magellan, which offers a high yield and operates in the generally stable industry of energy infrastructure.

"They are never moving pipelines to China," he says. MLPs are set up to avoid corporate taxes. They must receive 90% of income from commodities, natural resources, interest, or dividends, and are required to pay out 100% of profits. Magellan pays $2.84 a share annually, for a 7.4% yield, which Cameron expects to grow in coming years as U.S. energy infrastructure is modernized.

Along with talking to fund managers, we examined S&P's list of stocks that have increased annual payouts for at least 10 years and have estimated coverage ratios of at least two for 2009 and 2010.

Of 69 companies making the cut, the top-yielder, at 4.3%, is Universal (UVV), a Richmond-based tobacco grower with customers like giants Phillip Morris International and Japan Tobacco. With its largest customers selling cigarettes overseas, Universal is sheltered from U.S. legislation and declining smoking rates.

Also making the list was Johnson & Johnson (JNJ, Fortune 500), which we recommended last year as one of the best stocks to own in 2009. The pharmaceutical giant JNJ's 3.3% yield and 47 consecutive years of increasing dividends make the diverse manufacturer of everything from Band-Aids to Tylenol a strong pick in any environment.