The Safest Big Dividend in the S&P 500

01/05/2011 3:52 pm EST

Focus: STOCKS

Carla Pasternak

Editor, The Income Investor

A rural telecom operator wins the honors with a hefty payout that’s likely to persist through thick and thin, writes Carla Pasternak in Dividend Opportunities.

Thankfully, the draconian dividend cuts that we saw in 2008-2009 seem to be history. Believe it or not, these cuts added up to $52 billion in lost income during 2009—and that's just for the cuts from stocks in the Standard and Poor’s 500 index. To put that figure in perspective, losing $52 billion would put Warren Buffett into bankruptcy.

Today the news looks much brighter. Standard & Poor's reports that in the first three quarters of 2010, 1,033 companies increased payments (compared with 707 at this time in 2009). Even so, dividend safety still has its place. During the first three quarters of the year, 117 companies cut their payments.

To make sure you don't have to worry about dividend cuts, I've taken a look at every dividend-payer in the S&P 500 to find the safest yields available right now. Let's see who took home the title.

Safety Criteria #1: Yield
When it comes to yield, it usually takes something above 6% to garner even a second look from me. So I started my search with all the stocks within the S&P 500 that yield above that magic 6% number.

As I suspected, it turns out the common stocks in the S&P 500 don't offer much in the way of yields overall, but you can still find a few individual companies offering attractive payments. In total, eight stocks in the S&P (only 1.6% of the total) yielded 6% or more. Of those, the highest-yielding stock was Frontier Communications (NYSE: FTR), which pays investors 7.7% a year.

Safety Criteria #2: Earnings Power
It's not uncommon for "sick" stocks to carry high yields. Anticipating poor results, investors will dump the shares, boosting the yield. To combat this potential pitfall, I looked at the one-year growth in operating income for each of the eight stocks with a yield above 6%.

Operating income is the profit realized from the company's day-to-day operations, excluding one-time events or special cases. This metric usually gives a better sense of a company's growth than earnings per share, which can be manipulated to show stronger results.

Given the slow recovery in the economy, I searched for companies on my high-yield list able to manage any growth in operating income over the trailing twelve months, indicating the business was still able to thrive after one of the worst recessions in recent memory. After screening for positive one-year growth in operating income, I was left with the four candidates shown in my table:



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[As of Jan. 5, Frontier’s forward dividend yield was down to 7.7%, while Windstream’s had slipped to 7.2% and CenturyLink’s to 6.2%. Altria’s has remained at 6.2%—Editor.]

Safety Criteria #3: Dividend Coverage
No measure of dividend safety carries as much weight as the payout ratio. By comparing the amount of cash available each quarter to how much is paid in dividends, we can know whether a company can continue paying its current dividend even if conditions worsen.

For the payout ratios, I looked simply at free cash flow over the trailing 12 months, compared to dividends paid. Many investors look at earnings, but earnings can sometimes be misleading. Instead, free cash flow is a measure of cash generated by the company after capital expenditures. This cash can be used for just about anything—expansion, research and development, or most importantly, dividends. Here's what I found:



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You can see that all the high-yielders here had payout ratios under 100% based on free cash flow over the last 12 months. However, given Altria's 98% payout ratio, I did find it riskier than the rest of the list. Nearly all its free cash flow was spent on dividends. This doesn't mean the company will cut the payment, but the risk appeared much higher than for the other three members of our list.

Safety Criteria #4: Proven Track Record
To finally nail down what I think is the safest dividend in the S&P, I took a look at the track record of the three stocks left in the running.

I gave special credit to those companies that maintain—and raise—dividend payments through thick and thin. This shows dedication to paying dividends and also shows the company will maintain its payment should it hit a rough patch.

Looking into the track records of each of these companies yielded mixed results. Frontier Communications, which had the lowest payout ratio and highest yield, recently cut its dividend to $0.19 per share from $0.25. This reduced dividend should ensure its safety for the years ahead, but it does leave a sour taste in the mouths of longtime investors.

Apart from Frontier, both Windstream (Nasdaq: WIN) and CenturyLink (NYSE: CTL) have above-average yields and have demonstrated an ability to cover their dividends under tough economic conditions. 

If pressed, I'd have to tip the scale to Windstream, giving favor to its longer track record of paying high yields. But honestly, it looks like all three of our finalists should provide a high and stable yield for the coming years.

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