Veteran money manager Dick Dahlberg has some advice about where to find companies that are likely to increase their dividends this year: Forget about beleaguered banks and focus on telecommunications firms, health-care companies, stalwart consumer brands and other cash-rich businesses that are positioned to reward shareholders in a constrained economic and stock market environment.

"Over the next year, banks will have difficulty increasing their dividends, but other companies will pick up some of the slack," says the 68-year-old co-manager of the Columbia Dividend Income Fund.

Dahlberg says that because financials account for over one-fourth of all dividend-paying companies, the overall rate of dividend increases in 2008 is likely to fall behind levels for the previous three years. "In 2007, we saw a low-double-digit rate of increase in dividend payments," he says. "This year, I suspect that the lack of boosts by financials will bring that number down to somewhere in the mid-single digits."

The slowdown in dividends Dahlberg and others see ahead began quietly in 2007, when only 1,857 of the approximately 7,000 publicly owned companies that report dividend information to Standard & Poor's Dividend Record increased their dividends, which represented a 5.7% decrease from the 1,969 issues that raised their dividends in 2006. For the fourth quarter of 2007, dividend increases declined 10.6% to 432 from the 483 recorded during the fourth quarter of 2006.

Meanwhile, dividend decreases and suspensions picked up in 2007 amid the difficulties within the financial and consumer discretionary sectors. The current trend of companies favoring stock buybacks instead of making a long-term cash commitment to dividends has also contributed to the dividend drop.

Among the more publicized casualties this year has been bond insurer MBIA, which slashed its dividend by 62% in January amid concerns about a downgrade by credit-rating services. Last year, Washington Mutual cut its payment by over two-thirds to shore up its capital position. In December, the board of National City Corp., a bank that was hit hard by the subprime mortgage crisis, voted to cut its quarterly dividend in half.

The Columbia Dividend fund's 51-year-old co-manager Scott Davis says he and Dahlberg saw the cloud over National City coming earlier in the year when they decided to remove the stock from the fund's portfolio. "There were a lot of bad signs. Managers were buying back stock at very high prices and making costly acquisitions," he says.

National City joins the growing ranks of firms choosing stock buybacks over dividend payments. According to Standard & Poor's, companies in the S&P 500 index have spent more than twice as much on buybacks as they have on dividends over the last three years. Dahlberg says such activity is often a sign of management overconfidence and greed rather than a company selling at a bargain price.

"Many of the banks whose stocks have lost a third or more of their value were doing buybacks at very high prices last year," he says. "Companies often overestimate their prospects, and managers have a built-in incentive to conduct buybacks when their bonus and stock option compensation is based on how well a stock does. Buybacks aren't necessarily a bad thing, but they have to be done judiciously."

Dahlberg, who came out of retirement in 2003 to help manage the fund and who has been in the investment business for over 40 years, is also skeptical about stock options and acquisitions. He says the former are "a good way to dilute earnings and transfer wealth from shareholders to management," while acquisitions often result in badly matched corporate marriages and overpayment.

Cash Flow Kings

Dahlberg, who likens stock buybacks to "dating" and dividends to "marriage," says investors have reason to make dividend-paying stocks a portfolio staple in choppy markets. Once a company starts paying dividends, it usually continues to do so. Most resist making any cuts, and are often willing to increase payout ratios even when earnings are down. And while dividend increases within the general market have declined, over 60% of the S&P 500 companies increased their dividend payment in 2007.

Dividend plays help soften volatility and tend to fluctuate less than stocks that do not pay dividends, and they also contribute to total return over time. Since 1953, the reinvestment of dividends, on average, accounted for 29% of the annual total return of the S&P 500 index. The 15% tax rate on qualified dividends, extended through 2010 by the Tax Relief Extension Reconciliation Act, adds to their appeal.

Even though dividend yields overall are much lower than they were 20 years ago, and may not account for as much of the market's total return as they have in the past, the management duo believe they can still point the way toward financially sound companies with capital discipline and a history of sharing their good fortunes with shareholders. Companies that use free cash flow to increase their dividends consistently outperform the rest of the market over time, they contend.

After expenses, the fund's dividend yield clocks in at a modest 2%-enough to enhance total return but shy of the higher yields that some income-oriented investors crave. Still, the ten-year-old fund has a higher yield than 87% of its Morningstar category peers. An underweight position in credit-sensitive financials helped it end 2007 with a 6.7% return for the year, as many large company value funds with subprime mortgage exposure struggled.    

While it does have a hefty stake in financials-22% of assets at the end of the third quarter, compared with 19.4% of assets in the benchmark Russell 1000 index-the emphasis is on insurers such as Lincoln National, MetLife and Principal Financial Group, which are less vulnerable to credit meltdowns and mortgage problems. The potential for increased sales of annuities to retirees, as well as the growing 401(k) rollover market, is also a draw.

Instead of looking for the highest-yielding companies, the managers typically seek out those with moderate yields in the 2% to 3% range that have the wherewithal to increase dividend payments. The portfolio contains a mix of quality, recognizable and often unexciting blue chip names with a history of paying higher-than-average dividends and with reasonable valuations. Its 90 holdings have a median market capitalization of $83 billion, a trailing 12-month price-earnings ratio of 16.3, and a weighted average price-to book ratio of 2.9. Turnover for the most recent fiscal year was a modest 52%.

Dahlberg and Davis prefer using cash flow rather than earnings to arrive at a company's dividend payout ratio because the former measure is more difficult to manipulate. Red flags go up for the duo when companies start eating up too much of their cash flow to keep dividend payments afloat.

A desirable payout ratio depends on the growth rate of the company under consideration. Altria can pay out 60% to 80% of its cash flow in dividends because it is growing slowly and does not need to reinvest a lot of capital to expand, explains Dahlberg. But companies with higher growth rates, such as those in the electronics industry, must plow some of their cash flow back into their businesses to grow and will typically devote less of their cash flow to dividends.

Davis warns that this year may be a difficult one for some dividend-paying companies, such as General Motors, that are experiencing cash-flow problems. "The question is who will be able to sustain dividends and who won't. This is a good time to be in defensive mode," he says. Playing defense means continuing to steer clear of some stocks in the financial sector, which "will see more writing down over the next five or six months. The economic climate now is being driven by credit deterioration and excessive debt."

Telecommunications is another overweight sector relative to the benchmark, and the fund's largest holding, AT&T, accounts for nearly 5% of assets. Dahlberg and Davis began buying the stock about three years ago as a defensive play in what they viewed as a softening economy. "A few years ago, AT&T had been losing out to cellular and was given up for dead," says Dahlberg. "Now, landlines are a smaller piece of the business and the wireless side and other areas are accelerating." He expects earnings to grow at a 10% clip this year and sales to increase at a mid-single-digit pace. The company raised its dividend in December, boosting the stock's yield to a healthy 4%.

Retailing icon Wal-Mart Stores is one of the fund's newer positions and something of a departure from the norm for Dahlberg, who had taken a negative view of the retailer for many years because it had a penchant for using cash to open new stores at the expense of maximizing profits from existing ones. But a change in direction marked by a pullback on growth and the attention the company gave to weak sales at some of its stores prompted him to buy the stock last fall. Other holdings with ample free cash flow and room for dividend increases include General Electric, Altria, McDonald's, Anheuser-Busch, Coca-Cola, and Pfizer.