I just finished reading Bill Gross’ latest market commentary. It’s something I do every month. And I recommend you do the same.

Why?

Forget that it’s always entertaining, informative and often loaded with unconventional investment perspectives. Read it because the man controls a boatload of money.

At last check, his PIMCO Total Return Fund – the largest mutual fund in the world – boasted $159 billion under management.

With so much at stake, he can’t make investment recommendations flippantly. They require deep thought… and a track record of accuracy. Otherwise, investors wouldn’t keep entrusting him with their money.

So what’s he recommending now?

Bonds, of course.

After all, he is the Bond King, or “the nation’s most prominent bond investor” as The New York Times likes to say. Not doing so would be sacrilegious… and detrimental to his business.

But, he also likes “stable dividend-paying equities.”

Here’s my rub. He’s ambiguous. A “stable” dividend-paying stock is not self-evident. And investing in unstable dividend-paying stocks can lead to disastrous results (i.e. – a stock that cuts or cancels its dividend AND drops in price).

So let me provide you with a six-step screen to easily identify stable dividend-paying stocks.

How to Avoid the Dividend Trap… and Find Stable, High-Yield Investments

Countless studies demonstrate that dividend-paying stocks outperform non-payers by a wide margin.

From 1972 to 2006 dividend-paying stocks returned an average of 10% annually versus 4% for non-dividend payers, according to Ned Davis Research. Going back to 1926, other studies confirm almost half of the S&P 500’s return was due to the dividends paid by the companies in the index.

So, I’ll take Bill Gross’ recommendation one step further. Forget now. Dividend-paying stocks ALWAYS deserve a place in your portfolio.

Yet, in this market, it’s increasingly difficult to find reliable dividend stocks.

“This is going to be the worst [dividend-cutting year] in 50 years,” Howard Silverblatt, Senior Index Analyst at Standard & Poor’s, predicted in January. So far he’s right with industry titans like General Electric and Dow Chemical announcing cuts.

Keep in mind, Dow Chemical maintained or increased its dividend every year since 1912. That means conditions this year are worse for the company – at least on a cash flow basis – than during the Great Depression.

Against this backdrop, it’s understandable why many investors consider no dividend safe. But that’s a mistake. Fact is, countless companies will weather this storm with their dividend intact.

To find such companies I focus on the following six criteria and I recommend you do the same:

1. Simple business. The fewer the moving parts the fewer things that can go wrong and sap cash intended for dividend payments. Focus on companies doing one or two things that you can understand, as opposed to massive corporations with dozens of operating segments.
2. Steady demand. Given the Great Recession, the first thing we need to verify is demand for a company’s products. After all, a company needs a steady stream of cash coming in to afford to pay it out to shareholders. Stick to industries or sectors with recession-proof or recession-resistant demand (food, alcohol, tobacco, health care, etc.).
3. High cash balance. Cash IS king, especially when it comes to maintaining a dividend. Consider it insurance against any unexpected slowdowns. At a minimum, insist on enough cash to cover one quarter’s worth of dividends.
4. Minimal need for credit. Securing credit in this market is extremely difficult. Accordingly, I focus on companies that do not need to raise significant amounts of capital. Remember, too, when interest rates rise, so do interest payments for companies that rely on a significant amount of debt. So it’s also important to focus on companies with reasonable or low debt balances. This insures interest payments won’t sap money intended for us.
5. Cash flow positive. If a company’s not generating cash each quarter, the only way to pay a dividend is by borrowing or tapping into cash reserves. Such practices are not sustainable over the long term. Eventually, the dividend will be cut.
6. Earnings buffer. Insist on a dividend payout ratio (annual dividends/annual net income) of 80% or less. A company paying out 100% of earnings has no wiggle room in the event of a slowdown. If business suffers, so will the dividend.

Obviously not every stable dividend-paying stock will meet all these criteria. But the more criteria a stock fits, the more stable you can consider its dividend.

I followed these six criteria to unearth all the dividend stocks I’ve previously mentioned here – TEPPCO Partners (NYSE: TPP), Lorillard (NYSE: LO) and Windstream Corp. (NYSE: WIN).

Lorillard and Windstream remain attractive at current prices.

Next week, I’ll reveal another dividend-paying stock worth your consideration. But please note, in the days ahead my dividend-sleuthing prowess will change venues.

Louis Basenese
Investment U