How dividend investors can pick the right companies

The question is which companies investors can rely on to keep paying dividends.

During the pandemic, just under 200 companies stopped paying dividends to save cash. Over the past three years, many of them have resumed dividend payments—but some haven’t, and according to the latest Global Dividend Index from Janus Henderson, overall dividend growth is expected to slow to 2.3% in 2023.

Now, even as the economy continues to emerge from the worst of the pandemic disruptions, persistent inflation and higher interest rates are stressing companies’ balance sheets, which can discourage dividend payments. A handful of companies have recently announced plans to cut their dividends.

Max Wasserman, founder and senior portfolio manager at Chicago-based Miramar Capital, says that many of the indefinite pauses and recent cuts to dividends are a result of poor capital-allocation strategies.

“What you’re seeing are companies that have increased their payout ratio to such a high extent that any interruption in their business model has put their dividends in jeopardy,” Mr. Wasserman says. “Some companies have been stretching their balance sheets to remain dividend ‘aristocrats’ or to stay on the radar of mutual funds and dividend investors, and it’s hit their cash flows. With higher debt costs, inflation and uncertainty, they’ve made the decision to cut the dividend in response.”

Antonio DeSpirito, lead portfolio manager of the BlackRock Equity Dividend portfolios, says the timing of a dividend cut can tell investors about the underlying health of a company. “Work that we have done on this shows that if a business is making an out-of-business-cycle cut, that can be a sign of danger. That usually means there’s some long-term secondary issue at a company. The stock is less likely to recover,” he says. “If you see a business cut during a downturn, there is a better chance that stock is going to recover.”

Look for sustainability

So, what should dividend investors look for in a company? R. Burns McKinney, managing director and senior portfolio manager at Dallas-based NFJ Investment Group, says investors should look at cash flow alongside the company’s dividend. It can be tempting to look for the biggest dividends or the highest dividend yields, but cash flow is a metric of sustainability, he says.

“The best dividend companies are the ones that have thought it through and have a philosophy behind what they are doing with their dividend,” he says. “This should be rooted in current cash flow and their expectations for business growth over time.”

Both Messrs. McKinney and Wasserman argue that high-quality dividend payers should raise dividends meaningfully year over year, ideally keeping pace with inflation. Capital-allocation strategies should also account for the possibility of an economic slowdown or recession, they say. For 2023, both expect that high-quality dividend payers will increase payouts despite the pressure on corporate balance sheets from inflation and debt costs.

“The increases may not be sky high,” Mr. Wasserman says. “If a company has been raising the dividend by 5%, you might see them do 3% this year. But we expect to see increases, if that’s the path they have been on.”

A variety of strategies

For fund investors, dividend funds could provide some protection in the current market environment, says Daniel Sotiroff, a senior analyst at Morningstar Research Services, a unit of Morningstar Inc. “When you are focused on companies that are growing the dividend, that tends to mean that these are highly profitable companies. Investing in them can be a defensive investment in times of uncertainty,” he says. Last year, dividend funds were down 6.68% on average, compared with a 19.4% decline in the S&P 500 index, according to Morningstar.

Investors can pursue several different strategies with dividend funds. There are funds with a broad scope, such as Invesco Dividend Income Fund (FSTUX), which invests across sectors, in companies including longtime dividend payers like Johnson & Johnson and Bank of America Corp. It has an expense ratio of 0.66%.

Dividend-yield funds invest in companies that pay dividends at a higher rate than a specified benchmark index. Aniket Ullal, head of ETF data and analytics at CFRA Research, says these funds give investors the option of taking more of a sector view, as many of them invest primarily in one or two sectors.

Vanguard offers a dividend-appreciation strategy, through its Vanguard Dividend Appreciation ETF (VIG). The fund tracks the S&P U.S. Dividend Growers Index, which includes only companies with a record of increasing their dividends. The fund holds all of the stocks in the index and has an expense ratio of 0.06%.

“Each of these strategies are going to play different roles in a portfolio,” Mr. Ullal says. “There can be a trade-off when you focus on yields, because you increase the concentration risk in a portfolio. Each investor will have to decide if that is worth it to them.”

Ms. McCann is a writer in New York. She can be reached atreports@wsj.com.