The Most Promising Dividends in Water Utilities

Dividend payers deserve a berth in any long-term stock portfolio. But seemingly attractive dividend yields are not always as fetching as they may appear. Let's see which companies in the water utilities industry offer the most promising dividends.

Yields and growth rates and payout ratios, oh my!
Before we get to those companies, though, you should understand just whyyou'd want to own dividend payers. These stocks can contribute a huge chunk of growth to your portfolio in good times and bolster it during market downturns.

As my colleague Matt Koppenheffer has noted: "Between 2000 and 2009, the average dividend-adjusted return on stocks with market caps above $5 billion and a trailing yield of 2.5% or better was a whopping 114%. Compare that to a 19% drop for the S&P 500."

When hunting for promising dividend payers, unsophisticated investors will often just look for the highest yields they can find. While these stocks will indeed pay out the most, the yield figures apply only for the current year. Extremely steep dividend yields can be precarious, and even solid ones are vulnerable to dividend cuts.

When evaluating a company's attractiveness in terms of its dividend, it's important to examine at least three factors:

  • The current yield

  • The dividend growth

  • The payout ratio

If a company has a middling dividend yield, but a history of increasing its payment substantially from year to year, it deserves extra consideration. A $3 dividend can become $7.80 in 10 years, if it grows at 10% annually. (It will top $20 after 20 years.) Thus, a 3% yield today may be more attractive than a 4% one, if the 3% company is rapidly increasing that dividend.

Next, consider the company's payout ratio, which reflects what percentage of income the company is spending on its dividend. In general, the lower the number, the better. A low payout ratio means there's plenty of room for generous dividend increases. It also means that much of the company's income remains in its hands, giving it a lot of flexibility. That money can fund the business's expansion, pay off debt, buy back shares, or even buy other companies. A steep payout ratio reflects little flexibility for the company, less room for dividend growth, and a stronger chance that if the company falls on hard times, it will have to reduce its dividend.

Peering intowater utilities
Veolia Environnement
(NYS: VE) and Middlesex Water (NAS: MSEX) are among the stocks with the highest trailing yields, offering 13.5% and 3.9%, respectively. But companies with the highest yields are not necessarily your best bets. Veolia recently announced that it planned to cut its dividend by 42%, although even after the cut, the forward yield of over 7% still looks attractive. Meanwhile, Middlesex Water hasn't been growing its dividend too rapidly, and its payout ratio is a bit on the steep side. But it has been hiking its dividend for nearly 40 consecutive years, which is rather attractive. The company recently requested a 17.5% rate increase for its New Jersey operations.

Seeking a low payout ratio might seem smart, but by itself, it doesn't necessarily lead to higher dividend growth. American Water Works (NYS: AWK) , for example, sports a relatively low 51% payout ratio, but it has been raising its dividend by only about 4.8% annually over the past three years. It has been choosing to spend heavily on research and development and growth, partly by acquisition, over dividend payouts. That can benefit shareholders as much or more than dividend payouts -- if the company executes its strategy well.

Just right
As I see it, Veolia and Aqua America (NYS: WTR) offer the best combination of dividend traits. Despite Veolia's coming dividend cut, the yield is still extremely attractive. Aqua America yields a much lower 3%, but its dividend growth rate over the past five years has been a respectable 6.8%. Veolia is the largest publicly traded water company, earning a big chunk of its income from wastewater treatment and environmental cleaning services, which will likely remain in demand for the foreseeable future. Aqua America has been growing by acquisitions and has been embracing innovations in water treatment systems.

California Water Service Group (NYS: CWT) is also worth considering, though it hasn't been increasing its dividend very rapidly. It offers a solid yield near 3.5%, with a long track record of 45 consecutive annual dividend increases. It has been adding customers regularly, too, even in our recent tough housing market.

Of course, as with all stocks, you'll want to look into more than just a company's dividend situation before making a purchase decision. Still, these stocks' compelling dividends make them great places to start your search, particularly if you're excited by the prospects for this industry.

Do your portfolio a favor. Don't ignore the growth you can gain from powerful dividend payers.

Looking for someall-star dividend-paying stocks? Look no further.

Editor's note: A previous version of this article did not discuss Veolia's planned future dividend cut. The Fool regrets the omission.

At the time thisarticle was published

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