In a world of collapsing share prices and uncertainty about the outlook for earnings, strong stable dividends are a prized commodity, provided they are minted from pure gold and not the fool's variety. With the annual reporting season only weeks away, fears are mounting that tough economic times will force debt-laden companies to cut dividends.

Last week, Insurance Australia Group slashed its final dividend to a "more sustainable" level. And Australia's second-largest property trust, GPT, lowered its earnings forecast and distribution guidance by almost a third, triggering a 15 per cent plunge in the group's share price in one day.

In recent years property and infrastructure trusts, banks and utilities have been popular with investors seeking income, but each of these sectors has been under fire in the past six to nine months. "It's been a dreadful time for income-seeking investors," says Paul Zwi, head of equity research at Centric Wealth.

In the United States, 17 out of 20 financial stocks in the S&P 500 index have cut dividends this year. As the credit crunch has put the spotlight on financial stocks, the deteriorating economic outlook has forced companies in the food, entertainment and telecommunications sectors to reduce dividends.

Zwi says dividend-paying companies are attractive as they represent cash-in-hand, whereas earnings can be fudged with clever accounting.

But in recent times it has become clear that dividends can also be manipulated by paying them out of capital or borrowings and in that sense they may not be sustainable.

"It's important that dividends are sustainable and, if possible, growing over time, without weakening [the company's] balance sheet or future prospects," Zwi says.

This is a sentiment echoed by Lincoln chief executive officer Elio D'Amato. "You need to make sure a [dividend-paying] company is growing earnings and is expected to grow earnings in the future."

Paying dividends to shareholders is only one of four ways companies deal with the cash generated by their business. They can also keep the cash to reduce debt, spend it on the business or use it to buy back shares and thereby reduce capital.

Companies with a history of rewarding shareholders with steady dividend income face a conundrum. Dividends bring out loyalty in shareholders but in a market spooked by debt, D'Amato says, companies may feel pressured to cut dividends and use retained profits as a cheap form of funding.

D'Amato says a quick scan of ASX listed companies reveals that 242 pay a grossed-up dividend yield greater than the official cash rate of 7.25 per cent. But only four of those companies have gone up in price over the past 12 months.

"That old chestnut that dividends protect investors from market corrections has been proved in the last 12 months [to be] not the case," D'Amato says.

When times are tough, quality of earnings is all-important, as Steve Johnson, managing director of the Intelligent Investor, says.

The attraction of dividends should not be underrated, Johnson maintains, but it makes sense for some companies to plough earnings back into the business. However, if a company pays out all its earnings in dividends and profits fall, then dividends will fall as well.

Johnson cites Mortgage Choice as an example. It pays out 100 per cent of its earnings and has a fully franked dividend yield of more than 16 per cent, but with banks cutting commissions to mortgage brokers, he thinks the dividend may be under threat.

Johnson expects more dividend cuts in the next 12 months, especially among property and infrastructure trusts and retailers.

He says many trusts - and even market stalwarts such as Telstra - have been borrowing to prop up dividends, which is not sustainable. However, he thinks Telstra is unlikely to cut dividends because it should generate enough cash to fund payments within a year or two.

In recent years, defensive sectors such as property, infrastructure and utilities have used their steady income streams to support a highly leveraged structure. But, as debt became more expensive and scarce, that model no longer worked and their share prices have tumbled.

GPT made waves last week. High-profile toll group Transurban cut dividends last month and its share price toppled almost 26 per cent in June as a result.

Despite the recent carnage, the property trust sector had a distribution yield of 8.4 per cent at the end of June.

"You can get 8.25 per cent at call so why expose yourself to a high-risk investment vehicle?" D'Amato says. Even good trusts have been caught up in the brutal market sell-off and Lincoln continues to warn clients off the sector. Similarly, bank dividends grew at double-digit rates in recent years and last week the sector was trading on a fully franked dividend yield of 7 per cent. The million-dollar question, Zwi says, is whether that will be maintained. In his opinion, dividend cuts are possible but not probable, with bank earnings likely to be sufficient to cover dividends over the next year or two.

Despite the importance of dividends, recent market events highlight the dangers of focusing too narrowly on yield as a defensive strategy.

"Beware the dividend traps," Zwi warns. Sometimes yields can be artificially boosted by a fall in share price. (Dividend yield is derived by dividing the dividend by the current share price.) If the price has fallen because earnings are down or in doubt, it may be only a matter of time until the dividend is cut too.

For example, Lincoln recently removed employment services provider Clarius Group from its preferred stock list, despite a dividend yield of 16.3 per cent fully franked. This looks too good to be true - and it is. Dig deeper and you find that Clarius's share price has tumbled on a 23 per cent fall in earnings a share.

"A more sensible approach [to stock selection] is where you balance the search for high yields with a search for companies with a strong balance sheet, a strong franchise, pricing power and defensive cash flows," Zwi says.

"Woolworths is not a huge dividend payer, with a yield of about 3.8 per cent, but it has a wonderful franchise, a strong balance sheet, it's superbly managed and it sells consumer staples. If there's an economic slowdown then a company like Woolworths should do well."

As well as consistent earnings growth, Lincoln advises income investors to look for financially healthy companies with low exposure to debt, a simple and transparent business model and no bad news on the horizon.

For Money readers, D'Amato has selected eight stocks with a fully franked dividend yield above 7.25 per cent and a solid earnings outlook (see box).

"This is a long dark night for share investors," says Zwi, who believes investors have two choices. You can hide in cash at 7-8 per cent and forget stocks, which is a rational strategy. Or you can ferret out stocks you want to own over the long term, close your eyes to the daily and weekly volatility and let the dividends cover you while you wait for the market to recover.

"But there's no rush to buy. This is a good time to build up a quality portfolio at reasonable entry prices, but you need to be patient," he says.