As the dismal economy has dragged on, we’ve seen a record number of companies cut their dividend in an effort to save cash. Not surprisingly, data from Standard & Poor’s shows new record lows in the number of companies increasing their dividends.

S&P says that only 233 of the approximately 7,000 publicly owned companies that pay dividends increased their dividend payment during the second quarter of 2009; a nearly 50 percent drop compared to the same quarter a year ago.

This can put a serious dent in the budget of a retired person who relies on dividends for income and also thwarts those investors who are scouring the market for yield. Historically, dividends account for about 44 percent of the total return of the S&P 500. The current 12-month S&P 500 average dividend yield is 3.4 percent.

Sector breakdown by dividend
Source: S&P’s Index Services

“In terms of dividends, I think most of the carnage is over in the broad market,” says Matthew McCormick, portfolio manager and banking analyst at Bahl & Gaynor Investment Counsel in Cincinnati, an investment company that specializes in dividend stocks.

“There could still be some individual names, particularly in the financial sector, where you will see some cuts. We look at companies that have a history of, say, five years of consistently raising their dividend and have the free cash flow and the consistent earnings that can pay regardless of the economic environment. The theory is, and the practice is, if they can pay a dividend and they have a history like Procter & Gamble, increasing the dividend every year for the past 53 years, they will continue to do so,” he says.

McCormick isn’t buying the current train of thought that “buy and hold” is an outdated and dangerous stock portfolio philosophy that’s sure to lead to poor returns.

“If people want to be more nimble in their portfolio they can, but that requires more trading and more opportunities to be wrong. Our 19-year track record, as well as academic research, shows that if you buy these names and you hold on for the long term, you have very close to, if not better than, market-beating returns but with more income, less volatility and the ability to sleep better at night,” McCormick says.

If high yields are your cup of tea, be careful. Yields that are relatively high when compared to average yields may be fine, but digging for oversized yields can spell trouble, says Herb Hopwood, president of Hopwood Financial Services in Great Falls, Va.

“Historically, I think it’s much better to buy a stock that has a 2.5 percent to 4 percent dividend yield (and) that has the ability to raise its dividend 6 percent to 10 percent per year. That’s a much better strategy long term than reaching for yield. I think the markets are fairly efficient. There’s a reason why the yield is so high in so many cases. If you’re shopping just for the highest yield you’re potentially setting yourself up for a big fall.”

Hopwood suggests that most do-it-yourself investors stick with mutual funds that specialize in dividend income.

“Are (most investors) going to know to put in 20 different names in seven different industries if they’re buying individual stocks? How are they going to make those selections? It’s a tough thing to do. I understand that there are some lousy funds out there but if you’re going to (mutual fund companies, such as) Vanguard, T. Rowe Price, Fidelity or American Funds, you’ve got pretty good organizations. At American we use a fund called Capital Income Builder (CAIBX), and a large cap fund that we like a lot is T. Rowe Price Equity Income (PRFDX).”

Individual stocks?

If you do decide to select individual stocks for their dividends, be sure to understand how to interpret the company’s balance sheet, cash flow statement and payout ratio as well as the overall environment in which the company operates.

“Case in point might be something like McDonald’s, which we own,” says McCormick. “It has a 3.6 percent dividend that I would argue is much more secure than many others even though it’s higher than the average S&P 500 company. It comes down to the fundamentals, consistency of earnings and consistency of cash flow. What’s its footprint like? What’s its story? Does it have the ability to grow the dividend?”

“If you look at the 10-year Treasury note which is roughly 3.5 percent, I believe a name like McDonald’s offers a superior total return possibility (over the next 10 years); more so than a bond in which you just get your money back and certainly after inflation. Clearly, McDonald’s has the ability to grow their cash flow and earnings. I would argue that McDonald’s has better products and better management than our federal government,” he says.

Unfortunately, the government will take a slice of your dividend in most cases. The IRS Web site has information you’ll want to know about how your dividends are taxed.

Full disclosure: Laura Bruce owns shares of McDonald’s Corp.