Until last year, dividends were taxed like ordinary income, up to a staggeringly high 38.6% tax rate. By contrast, long-term capital gains were taxed at a 20% rate. That, combined with a roaring bull market, led many investors to gravitate toward high-growth, non-dividend-paying stocks in the late 1990s, as these stocks allowed investors keep a larger chunk of their winnings. However, thanks to recent tax law changes implemented in 2003, the playing field has now been leveled and a 15% tax rate applies equally to both dividends and capital gains (at least through 2008).

In addition to recent tax changes, many other factors have been driving renewed interest in income stocks. For starters, because so many companies were quick to take advantage of the 2003 dividend tax cuts, there's now a much bigger selection of dividend-paying stocks to choose from. Instead of buying back shares to boost their stock price, more and more companies have started to offer or increase their quarterly dividend payments. In fact, twice as many firms initiated or raised dividends last year relative to the year before. Whereas just 113 companies raised or initiated dividends in 2002, a full 229 companies stepped up to the plate last year. These included such blue chips as Microsoft (MSFT, $26.35), McDonald's (MCD, $29.85), Qualcomm (QCOM, $63.88), Cendant (CD, $23.86), Goldman Sachs (GS, $109.05), Bank of America (BAC, $82.74) and Citigroup (C, $50.00).

HISTORY PROVES DIVIDEND PAYERS OUTPERFORM NONPAYERS
It's easy to underestimate the benefits of owning income stocks. However, to do so would be a huge mistake. Although many investors are unaware of it, a look back a market data over the past 75 years shows that nearly half of the market's total returns have come in the form of dividends. Between 1926 and 2003, dividends contributed 42% of the total return delivered by the S&P 500. Also, it's been calculated that $1 invested in the S&P 500 in 1926 would be worth today $2,260 if reinvested dividends are included, but only $90 without the dividends.

If history is any guide, then dividend stocks should also perform better than their non-paying peers over the long haul. Studies have shown dividend payers outperformed non-payers from 1970 to 2000. Their stock prices were also 10% less volatile, meaning they could be counted on to deliver steady returns throughout both good times and bad.

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WHAT MAKES A GREAT DIVIDEND STOCK?

About 2,000 domestic U.S. stocks currently pay dividends, but not all dividend stocks are created equally. And herein lies the catch.

In searching for high-quality dividend stocks for readers of our newest newsletter feature -- "Income Watch" -- we regularly review hundreds of different stocks. We then narrow this vast investing universe down to a short list of about dozen different companies. How do we separate the winners from the losers? Well, for starters, we always keep the following key measures in mind:

1. Give Me More!
When looking for high-quality income stocks, we only want to invest in companies that pay an above-average dividend yield (calculated by taking a firm's annual dividend payment and dividing that figure by its current stock price). In this market, that means a yield of at least +2.5%. Such a yield compares favorably with the average of about +1.8% for all 356 dividend-paying stocks in the S&P 500.

2. Can They Afford It?
Remember -- corporate dividend payments are by no means guaranteed. In fact, companies that pay out excessively high dividends are often forced to lower those payments (or even halt them altogether!) during economic downturns. In addition, rich dividends are often a sign of overly conservative management, or of sluggish companies with nowhere else to invest their cash (in other words, companies with limited growth prospects).

On the other hand, income investors certainly want to seek out companies that offer sizable dividends for income purposes.

So, what's the most appropriate dividend payout amount? Deciding whether a company is paying too much or not enough can be tricky, and defining a reasonable payout ratio (calculated by taking a firm's dividend payments and dividing that figure its earnings over a certain time period) is more an art than a science. A high dividend payout ratio means the company is very generous in distributing income to shareholders. If the ratio is too high, however, then the company may not be reinvesting enough of its cash flow into growing its business. In the most recent 50-year period, the average dividend payout ratio has stood at about 50%. In the bull market of the 1990s, that ratio dropped to about 30%. It now averages roughly 35%.

It's also important to keep in mind that payout ratios vary with the type of stock. The payout delivered by growth stocks, for instance, is generally less than what you'll see for most banks or utilities. Microsoft's (MSFT, $26.35) payout currently stands at about 30%, compared to Bank of America's (BAC, $82.74) 40% and Consolidated Edison's (ED, $44.90) 70%. For today's issue, we focused on moderate growth issues with payout ratios between 40% and 60%.

3. Show Me the Money!
No matter what your objectives are, it's critical to examine the long-term fundamental prospects for any investment you make. With this in mind, instead of blindly looking for high-yielding stocks, you should search for solid companies with sustainable, growing dividend payments. High-yielding stocks that lack the fundamentals to support that yield aren't worth your time or money, so we'd strongly urge you to steer clear of them. In fact, if you're ever tempted to invest in a company just because its stock offers an unusually high dividend yield, just think of all the folks who lost millions by investing in shares of MCI, which at one time sported an impressive 20-30% dividend yield. Soon after, however, the company was forced to cut that yield amidst a corporate meltdown that ultimately ended up in bankruptcy.

As a general note, please remember that although the equity markets aren't perfectly efficient, they're pretty close. Therefore, if you see a stock that boasts a dividend yield in excess of, say, 15%, then chances are the firm is in major trouble and will likely be forced to lower its dividend payout in the near future. After all, if Wall Street truly believed the company's dividend payout was sustainable, then investors would quickly bid up the firm's shares, thus driving down its dividend yield to much more average levels.

Finally, keep in mind that unlike bonds, corporate dividend payments aren't legally required. Companies can cut or eliminate their dividend payments at any time. As an income investor, you want to invest only in stable, growing companies that will generate enough cash flow from operations to cover their dividend through good times or bad.

4. Look at the Record.
When investing in income stocks, we prefer companies with long and reliable dividend track records. An upward trending dividend record is often a sign of real financial strength. The three quality companies we identify below have been paying dividends at increasing rates for decades upon decades and should continue to do so for years to come. As a more general note, the good news for investors is that dividend payments are on the rise. Last year, dividend payments increased about +8% over the previous year. Looking ahead to the rest of 2004, Standard and Poor's is forecasting another banner year with average dividend payment increases of nearly +11%.

AND THE WINNERS ARE...
Our most recent search for high-quality income stocks led us to three top picks. Although these companies cover a wide range of industries, all three share certain key advantages. Their stock prices are relatively cheap compared to their peers. In addition, they all boast solid fundamentals and generate robust cash flow. And finally, each has a longstanding record of delivering stable, growing dividends payments year-in and year-out. The three stocks we're going to profile today include Sara Lee (SLE, $22.32), which pays an above-average yield of +3.4%, Altria (MO, $58.22), which yields a hefty +4.7%, and Merck (MRK, $48.10), which offers a yield of +3.1%.

SARA LEE (SLE, $22.32) -- Sara Lee has a strong presence in the food, household and apparel business. The firm's well-known brands range from Sara Lee cheesecakes and Ball Park franks to the "Wonderbra" and Hanes underwear. A global leader, Sara Lee operates in 55 countries and markets its products in 200 countries across the globe. The firm's 75-cent annual dividend gives the stock a yield of +3.4% based on current share prices. Over the past five years the company has boosted its dividend by an average of +6.5% per year. The firm's dividend payout is relatively high, representing about 49% of company earnings. This helps to support the firm's stock price.

With a forecasted long-term earnings growth rate of only +7%, Sara Lee is by no means an aggressive growth stock. However, the company has proven to be a steady, reliable, income-generating investment over the past several decades. With $1.31 billion in annual free cash flow, Sara Lee should have no trouble covering its dividend. Meanwhile, management should continue to make progress on a number of different fronts. For example, in an effort to refocus operations around core business units, the company recently divested several businesses. Management plans to use the proceeds from these sales to repurchase stock, retire debt, and fund future acquisitions. With a price/earnings ratio of around 15 compared to the industry's 20, Sara Lee trades at a discount relative to its peers. Investors should benefit from the firm's solid dividend yield while the company continues its turnaround efforts.

ALTRIA (MO, $58.22) -- Altria is a food and tobacco conglomerate that includes tobacco titan Philip Morris and majority ownership in Kraft Foods (KFT). The stock pays a generous $2.72 annual dividend and has increased that payout by nearly +10% per year over the past five years. Based on current stock prices, that equates to a robust dividend yield of 4.7%. Meanwhile, the company's payout ratio stands at an above-average 58%. On the operational side, Altria is highly profitable, with profit margins of over +11% and a five-year earnings growth record of +15%. In terms of risk, the company continues to face a number of multi-billion dollar legal challenges, which could ultimately threaten its performance. However, assuming that Altria doesn't get overburdened with legal troubles, the firm's solid cash flow and its high dividend yield will cushion some of the risk here. On that front, we're encouraged by the company's outlook. Its dividend is amply covered by strong cash flow, which has increased +10% annually over the past decade.

Important Note: We understand that for a variety of reasons (primarily the firm's involvement in the tobacco industry), Altria might not be a suitable stock for many investors. With that in mind, we'd like to assure you that at StreetAuthority.com, we will always make every effort to invest in a socially responsible manner. Therefore, we have decided not to add Altria to any of our recommended portfolio holdings for any of our newsletters. On the other hand, we also feel a strong responsibility to inform our readers of some of today's most attractive-looking income stocks, and Altria is certainly one of them. As with any other investment choice you might make, the final decision of whether or not to invest in this firm is entirely up to you. Please use this newsletter for informational purposes only.

MERCK (MRK, $48.10) -- One of the world's largest drug firms, Merck (MRK) develops, manufactures and markets a wide range of prescription drugs, including cholesterol drug Zocor and Vioxx for arthritis (the company's two best-selling drugs). This stable drug giant delivers an annual dividend payment of $1.48 per share, which equates to a +3.1% dividend yield. The firm's payout ratio stands at 48%. Merck has raised its dividend for 16 consecutive years, and given the firm's strong fundamentals, we fully expect this streak to continue in the years ahead. On the operational side, management has come under intense pressure to replenish the firm's aging drug pipeline. However, our view is that the company has the resources and the expertise to ultimately meet that challenge. For example, in an effort to re-enter the cancer drug market, Merck recently announced a buyout of privately held Biotech firm Aton Pharma. Despite its sluggish growth as of late -- the firm's earnings grew by less than 1% last year -- Merck continues to throw off free cash flow of more than $7 billion per year, allowing the firm to easily cover its dividend payments. Based on the company's long-term track record and our expectations for an improving drug pipeline in the coming years, shareholders should be rewarded for their patience over the long haul here. Meanwhile, Merck should continue to deliver above-average dividend payments for income-oriented investors.

WINDOW OF OPPORTUNITY
Value/income stocks like the ones we've profiled today are not without risk. However, the fact that these companies have not only been paying dividends year-in and year-out, but have also increased those dividends on a regular basis, suggests they will continue to do so for many more. Of course, historical performance is by no means a valid predictor of future success. However, since each one of these companies generates strong annual cash flow, all three should have no trouble covering their dividend payments in the future. Moreover, all three firms have the potential to deliver stable cash flow growth in the future, which should allow them to continue to boost their dividend payments down the road. Despite the swift market run-up we've seen over the past year, astute investors still have a window of opportunity to scoop up these high-yielding, fundamentally-sound companies at reasonable valuation levels. Although none of these stocks are aggressive, high-growth plays, they should deliver stable growth over the long haul for patient investor. And the best part is, you'll get paid handsomely while you wait.

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