The Safest Dividend in the S&P 500

By DividendOpportunities.com

If you’re a longtime Dividend Opportunities subscriber, you might remember an issue back in November where I hunted down the safest dividend in the S&P 500.

The response to the article was overwhelming. So I decided to provide an update to my newest readers — taking the same rigorous metrics I applied before to discover where the safest dividend in the S&P is today.

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

Today the news looks much brighter. Among the 7,000 companies that report dividend information to Standard & Poor’s, there were more than 1,700 dividend increases in 2010, compared to just 145 decreases. And so far in 2011, companies are on pace for more than 1,800 increases. Even so, dividend safety still has its place for any income investor.

So 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 takes home the title…

Safety Criteria #1: Yield

When it comes to yield, it usually takes something above 5% 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 5% number.

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. (For the record, I typically broaden my income search to include closed-end funds, exchange-traded bonds, master limited partnerships — and a bevy of other asset types — to bring readers of Dividend Opportunities and my premium High-Yield Investing newsletter the most attractive yields.)

In total, just 19 stocks in the S&P (only 3.8% of the total) yield 5% or more. Of those, the highest-yielding stock is Frontier Communications (NYSE: FTR), which pays investors 10.2% a year.

With this handful of stocks in focus, I turned to my next metric to uncover the safest dividend: earnings power.

Safety Criteria #2: Earnings Power

It’s not uncommon for “sick” stocks to carry high yields. Based on a poor outlook, investors will dump the shares, boosting the yield. To combat this potential pitfall, I looked at the 1-year growth in operating income for each of the stocks with a yield above 5%.

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 is still able to thrive after one of the worst recessions in recent memory. After screening for positive 1-year growth in operating income, we’re left with the 13 candidates shown in my table:

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 against 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 at free cash flow over the trailing 12 months (TTM) 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:

You can see that many of these high-yielders don’t cover their dividends with free cash flow (shown by a ratio above 100%). This doesn’t necessarily mean the company will cut the payment, but the risk appears much higher than with the other members of our list. So in the search for what I think is the safest dividend in the S&P 500, I kept my focus only on those seven companies seeing enough free cash flow to cover their dividends.

Safety Criteria #4: Proven Track Record

To finally nail down what I think is the safest dividend in the S&P, I looked at the track records of the seven 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 offers mixed results. Frontier Communications, which has highest yield, recently cut its quarterly dividend to $0.188 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. So while I think the dividend is safe, I want to look elsewhere.

Meanwhile, Ameren Corporation slashed its dividend nearly in half at the peak of the 2008-09 bear market.

The rest of our candidates all have above-average yields and have demonstrated an ability to pay their dividends under tough economic conditions.

But that doesn’t mean I’d consider them all to be the safest. For example, pharmaceutical company Eli Lilly has to deal with upcoming patent expirations on many of its drugs, which could cause issues. And HCP, Inc. — a healthcare REIT — has to contend with cuts to government healthcare spending in the coming years. On Monday its shares were down 6% on news of cuts to Medicare payment rates.

If pressed, I’d have to tip the scale toward one of the three telecom companies on the list — Windstream, CenturyLink, and Verizon. These are usually highly stable businesses, especially when compared to other industries. And based on the analysis above, it looks like these three telecoms should provide a high and stable yield for the coming years.

Good Investing!

Carla Pasternak’s Dividend Opportunities

P.S. — If you want more high-yield ideas, be sure to watch the presentation my colleague Dan Moser put together outlining some of the best income opportunities on the market. You can visit this link to start watching now.