Dividends: It's Payback Time!

SmartMoney by Ben Levisohn

Slow economic growth. Whipsawing volatility. In an environment like this, it is little wonder investors are piling into stocks with steady dividend payments.

Mutual funds specializing in dividend stocks have seen inflows of $12.6 billion so far this year, four times as much as in all of 2010 -- even as stock funds as a whole have posted outflows of nearly $25 billion, according to fund tracker Lipper.

The key to dividend investing, say strategists, is to be selective. That means avoiding the juiciest dividends and concentrating instead on companies that are boosting their payouts -- and have the growth potential to keep those payments coming.

"You should never be taking shortcuts," says Ben Inker, director of asset allocation at money manager GMO LLC in Boston. "Just because a stock pays a dividend doesn't mean you don't have to worry about the rest of the company."

At the same time, a low yield might not be a problem if the company seems poised to raise its payment. Take UnitedHealth Group (UNH: 45.73, -1.29, -2.74%) Inc., a favorite of Richard Helm, manager of the Cohen & Steers Dividend Value Fund. It has a yield of just 1.2%, but it raised its dividend payment from three cents per share to 50 cents in 2010, and then raised it again in May 2011 to 65 cents.

"We favor those that have lower payout ratios, but higher rates of dividend growth," says Mr. Helm, whose fund is down 6.7% so far this year, better than the S&P 500's 7.8% decline through Thursday.

Of course, a fat yield does no good if a company can't make its payments in the future. How do you tell if a dividend may be unsustainable? First, look at a company's payout ratio -- the dividend payment per share divided by earnings per share. A common rule of thumb: If the number is more than 50%, the dividend may be too high, especially for companies where earnings fluctuate with the economy.

In stable sectors, such as utilities and telecommunication companies, higher payout ratios might not be a sign of trouble because companies' income fluctuates less.

Financial planner Emily Sanders, chief investment officer of Sanders Financial Management in Norcross, GA passed on buying Frontier Communications recently, choosing Verizon, PepsiCo (PEP: 63.30, -0.85, -1.33%) Inc. and Abbott Laboratories (ABT: 51.04, -0.90, -1.73%) instead.

"We decided that the stability of the dividend wasn't ensured enough to buy the stock," Ms. Sanders says.

A high-yield, low-beta strategy would steer you toward consumer staples like General Mills (GIS: 37.41, -0.30, -0.80%) Inc., which pays a dividend yield of 3.3% and has a three-year beta of just 0.2. Utility PG&E (PCG: 41.34, -0.75, -1.78%) Corp. yields 4.4% and carries a beta of 0.2; and health-care company Abbott Laboratories yields 3.8% and has a beta of 0.3.

Several mutual funds and exchange-traded funds generated fatter yields than the S&P 500 and provided more safety. The SPDR S&P Dividend (SDY: 50.19, -1.10, -2.14%) ETF, which tracks the S&P High Yield Dividend Aristocrats index of S&P 500 companies that have raised dividends every year for 25 consecutive years, has dropped 8.6% in August, compared with a 13.1% fall for the S&P. It yields 3.3% and has a beta of 0.88.

Other investors might prefer more upside potential alongside a fat yield. One strategy: build a portfolio that pays a high dividend but tracks the S&P 500. By leaning toward stocks with above-average yields, but higher betas, investors can match the S&P's price gains while beating it on a yield basis.

Joe Wolfe, director of quantitative research at Northern Trust (NTRS: 36.53, -1.49, -3.92%) Corp., recommends higher-beta dividend payers like Microsoft (MSFT: 25.80, -0.41, -1.56%) Corp., which has a dividend yield of 2.6% and a beta of 0.98, and Intel (INTC: 19.64, -0.35, -1.75%) Corp., which has a dividend yield of 4.3% and a beta of 1.1.

Among the higher-beta dividend payers that Jeff Layman, chief Investment Officer at BKD Wealth Advisors LLC in St. Louis, has been accumulating for his clients are ConocoPhillips (COP: 66.44, -1.53, -2.25%), which yields 4% and has a beta of 1.2, and Aflac (AFL: 34.99, -1.70, -4.63%) Inc., which yields 3.4% and has a beta of 2.0.

High-beta income ETFs include First Trust Morningstar Dividend Leaders (FDL: 16.06, -0.27, -1.65%), which yields 3.7% and has a beta of 0.9, WisdomTree Equity Income (DHS: 39.23, -0.73, -1.83%), which yields 3.6% and has a beta of 1.1, and the Vanguard High Dividend Yield (VYM: 41.36, -0.85, -2.01%), which yields 2.82% and has a beta of 1.

"In the future, dividends will be a stronger portion of returns," Mr. Wolfe says. "But we want market exposure too."