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%.