Dividend-paying stocks offer security in lean times. Here's how to spot the good ones. March 15, 2005 Dividend payers versus growth stocks -- it's the choice between swinging for singles or swinging for the fences. In the early stages of an economic recovery, the sluggers tend to win. But as the economy gains steam, the focus inevitably returns to dividend payers -- companies that provide regular payouts to their shareholders. They're cheap compared with growth stocks, and their staid business models won't look so boring when an earnings hiccup knocks 20% off the price of last month's high-tech wonder. Why they appeal Think of dividend stocks the way Linus thinks of his blanket -- as a source of security. Companies that pay dividends tend to be in better shape financially, says John Carey, manager of the Pioneer Equity Income Fund, which looks for cash-yielding equities. "They have better accounting practices and they tend to care about their shareholders more," he says. That can be reassuring, considering the number of companies that have come under question recently for the way they handle their books. Advertisement Plus, dividend-paying stocks tend to be less volatile than stocks that pay no income. And it looks as if this year will show more of the same. In addition to providing a cushion during lean times, these stocks tend to be consistent earners, since earnings support the dividend. Newspaper-giant Gannett (GCI), a stock with a 1.2% yield, grew about 26% in 2003 -- boosting its earnings despite the ad recession. An added bonus: The recent tax cut on dividends. In the past, Uncle Sam taxed dividends at an investor's marginal rate (currently as high as 35%). Now they are taxed at a maximum of 15% -- the same as the capital-gains rate on profits from the sale of a stock you've owned for a year or more. That goes a long way toward putting dividends on an equal footing with capital appreciation. Most companies that pay dividends also have dividend-reinvestment plans (DRIPs), which let you reinvest your payouts in shares of stock without paying a broker a commission. (You can see a list of DRIPs at InvestorGuide.com.) Signs of a good stock The company has lots of cash. Make sure the company has plenty of cash on the books and that the dividend is coming from excess cash flow. After shareholders are paid, there should still be room for capital spending and things like acquisitions, research and development, and share buybacks. Advertisement You can tell how much cash a company is using to cover its dividends by looking at the payout ratio, or the percentage of earnings paid out in dividends over time. The yield isn't sky-high. It's the extremes that you want to avoid. "If a stock pays a sky-high dividend, it could be a red flag," Carey says. For example, nonutility stocks that yield more than 5% (divide the annual dividend by the current share price to get the yield) may be companies in distress or in risky turnaround situations. Be confident that a high yielder is generating enough free cash flow (cash left over after expenses, interest, taxes and capital expenditures needed to maintain the business) to pay the dividend. Otherwise, it may have to cut its payout or dip into previous years' profits to cover it. There are exceptions. REITs (real estate investment trusts) and master limited partnerships can pay seemingly huge dividends because they add return on capital to cash earnings to come up with a dividend payout, while other stocks just use regular, cash income. The company has raised its dividend consistently. Look for stocks that have above-average rates of dividend increases. For example, Midwest banker National City Corp. (NCC) has raised its dividend for 12 straight years, and it recently yielded 3.97% annually. Use Stock Finder to screen for dividend-paying stocks that fit your criteria or to check out our special pre-assembled dividend stock screen.