Dabble in Dividends

• ByTim Melvin, RealMoney.com Contributor
• On Wednesday November 12, 2008, 3:01 pm EST

At times, it does seem like the world is ending. Tuesday was one such day as the market continued the steep selloff of the last month or so. Reading the earnings releases during the day was deeply depressing. Almost no one had a good quarter, and it seemed everyone was taking down forecasts for the fourth quarter.

Retail is a total disaster as far as earnings go. We see retail sales figures on Friday, and based on what we have seen so far, they will likely be worse than expected. There may be a bright spot from Wal-Mart and some of the other discounters, but most stores are having a very tough time right now. All of this is reflected in stock prices, and we appear to be on the way to testing last month's lows in the stock market.

I have made it no secret that I have been buying stocks in recent weeks. In fact, I purchased stock in more companies in this short period of time than I have ever done in my 20-plus-year career.

I have been equally vocal about the need for a cautious approach. I am moving in much smaller increments than usual. I always assume that anything I buy will go down right after I get confirmation of the trade, so I tend to average into my positions. I am also aggressively selling calls against all of the optionable stocks, and I am long an inverse ETF to protect against adverse market-related moves.

I know that the economy will improve some day, but I cannot claim that I have any idea as to when. While I want to take advantage of the incredibly cheap stocks I am seeing, I also want to be careful. Government moves have changed the rules, and we are very much in unchartered waters. The trick right now is not to sink before you get the cargo of cheap stocks to your destination.

Another way to gain some measure of protection against adverse market conditions is to focus on dividends. Dividends can provide an immediate return and a possible cushion against price moves. Right now, you can find some high-quality companies that have dividend yields higher than you can get on bonds and that have long-term appreciation potential as well.

For years, I have used a screen of stocks that pay healthy dividends and have a history of raising that dividend at least as fast as the inflation rate. Until last year, it boasted returns that were higher than the market with much less volatility.

The one thing you have to watch out for when using this approach, however, is that you can end up with far too much concentration in certain industries. Last year, the screen was full of energy and financial stocks, which, as we now know, would have resulted in fairly large losses. Since much of the carnage of that storm seems to have passed and many of the stocks would no longer qualify due to dividend cuts, I ran it again yesterday and added the criterion of analysts' expectations that the dividend would grow at least at 4% for the next five years.

Surprisingly, a few bank stocks did make the cut. Companies such as Astoria Financial , SunTrust Banks and Susquehanna Bancshares have managed to avoid a lot of the bullets whizzing around this sector over the past year. Earnings are down along with the stock prices, but the companies do not have toxic securities exploding on the balance sheet. Astoria yields 5.7% at today's price, and the other two both have yields over 7%. If you can stomach the volatility of the sector, you get paid to wait with these banks, and the dividends are expected to grow for all three.

You do not have to buy banks to get dividends however. Kinder Morgan Energy is the largest pipeline master limited partnership in the U.S. The company owns over 25,000 miles of pipeline and 165 terminals for petroleum products. It is one of the few companies for which analysts are raising their earnings expectations. The units yield 7.6% today, and that payout is expected to be increased by better than 7% annually.

Pharmaceutical giants Pfizer and Bristol-Myers Squibb make the list as well. Drug stocks may not be exciting in the short term, but both of these big pharma plays sport generous yields that are expected to grow over the next several years.

A few high-quality insurance companies are also among the high-yielding stocks. Allstate is the largest property and casualty insurer in the country. Along with other financials, the stock has been beaten down this year, down 50% from its highs. The company's dividend is strong in spite of losses in its investment portfolio, however, with a yield over 6% at today's price. Mercury General is a low-cost provider of auto insurance and is gaining market share. Mercury yields 5% at current levels.

You can also invest in an eventual economic and consumer rebound with companies such as Mattel , Harley-Davidson and Oxford Industries , all of which yield better than 5% and have long-term recovery potential.

Dividends can help you survive the current market. Again, they provide a cushion against price swings and immediate cash flow. Buy small, expect to add your positions at lower prices, and I suggest hedging your overall portfolio. Over time, a portfolio of high-yielding stocks with a track record of raising their dividends can substantially outperform the stock market. It is time to start building a portfolio of these stocks. Cautiously.