Investing Strategies: Dividend Investing

Pssst ... Hey, kid! Over here! Have I got a hot investment tip for you! I know about a group of stocks that have beaten the market, paid cold, hard cash along the way, and done so with less volatility than the Standard & Poor's 500 Index. You want to know what these stellar investments are? Lean in a little closer, and I'll tell you.

High-yielding stocks.

Yes, that's right -- stocks that pay generous dividends. Countless studies have found that high-yielding stocks outperform their stingier brethren, and do so with less risk. Investment bank Lehman Brothers found that from 1970 to 2005, the top-yielding quintile (the one-fifth of stocks with the highest yields) returned an annual average of 13.7%, compared to just 9% for the lowest-yielding quintile. As for risk, the standard deviation (a common measure of volatility) of the two groups was 15.5% and 29.1%, respectively. When you're talking standard deviation, a higher number means wider swings, so the top-yielding 20% of stocks were half as volatile as the lowest-yielding 20%.

In The Future for Investors, Dr. Jeremy Siegel of Wharton Business School explains that after the creation of the S&P 500 in 1957, the stocks with the highest yields outperformed the S&P 500 itself by an average of 3% a year. The lowest-yielding stocks underperformed the S&P 500 by almost 2% a year.

Those are just two of the many studies that establish exceptional return potential of high-yielding stocks. But a market-beating return isn't the only reason to seek out companies that dole out dividends. Those dividend checks tend to grow over time, at a rate that far exceeds inflation if you choose the right companies. Check out the annual dividend growth rates from 2002 to 2007 for these stalwart stocks:

Stock

Annual Dividend Growth Rate (2002 to 2007)

Dividends Paid Since

General Electric

9.2%

1899

Wrigley

13.4%

1913

Caterpillar

13.5%

1914

Johnson & Johnson

15.3%

1944

Pfizer

17.4%

1901

Inflation*

2.7%

N/A

*Inflation for 2007 was CPI for previous 12 months as of September 2007.

And the dividend goes on
So while a stock's share price can go up, down, and all around, the dividend of a solid company usually goes in just one direction: higher. This has important practical implications, depending on what you plan to do with those dividends:

  • If you spend your dividends, perhaps because you're retired, that portion of your income will keep up with the rising cost of living, and then some. Throw in the fact that qualified dividends are taxed at the rate of long-term capital gains (5% to 15%) rather than ordinary income (10% to 35%), and you can't help but see dividends as a tax-advantaged way to get inflation-beating income.
  • If you reinvest your dividends, you have built-in, supercharged dollar-cost averaging, buying more shares when prices are down and less when shares get more expensive. "Supercharged" because those dividends -- and, thus, reinvestments -- get bigger every year. Once you retire, turn off the reinvestment, and you have the aforementioned inflation-beating income stream.

Key metrics
1. Yield: The astute among you may have noticed that not all of the stocks in our chart have been great investments over the past five years. A growing dividend alone does not equal a great investment. It's important to measure the size of the dividend relative to the stock's price. Yes, we're talking about yield: the past year's worth of dividends, divided by the current stock price.

As the stock price drops, the yield goes up -- which is why yield is often used as a measure of value. Often, a stock gets beaten down so much that the yield skyrockets. Financial stocks often pay decent dividends, and during the subprime mortgage mess, yields have been even higher.

Eventually, investors won't be able to resist such attractive yields. So they'll pile into beaten-down financial stocks and drive the prices up, rewarding those shareholders who held on through dark times.

2. Payout ratio: Some stocks don't pay big dividends, and some don't pay any at all. The degree to which companies pass profits on to shareholders is measured by the payout ratio: dividends paid divided by net income (i.e., earnings). The payout ratio is used to spot stocks paying out more than they earn; a company earning $1 per share but paying a $1.20 dividend can't keep it up for very long. You can find the payout ratio for any stock by entering its ticker in Yahoo! Finance, clicking on "Key Statistics," and looking in the "Dividends & Splits" box. Keep in mind that earnings can be manipulated -- especially in the cases of master limited partnerships and real estate investment trusts, investments valued for their dividends -- so keep an eye out for a big increase or decrease in a company's payout ratio.

3. Dividend consistency: If you're investing in a stock at least partially for the dividend, you want that payment to continue, and even increase. When the opposite happens -- a company cuts its dividend or eliminates it altogether -- investors become unhappy and take it out on the stock. Thus, you want to choose companies with a long history of giving cash back to shareholders.

Some exchange-traded funds (ETFs) have started focusing on dividend-paying stocks. These funds do the research for you, investing in the highest-yielding stocks that have maintained or grown their dividends for several years in a row.

You buy a stock not to own a piece of paper, but to be a part-owner of a business, with a stake in its earnings and increases in value. Stock prices are subject to the whims of the market, but a dividend is a bird in the hand; it's a check you can cash and put in the bank. And history shows that making value-oriented, dividend-paying companies the foundation of your portfolio -- from 50% to 80% of your stock investments -- has paid off in the long run.

Want to learn more? Our Motley Fool Income Investor newsletter has lots of useful information, including stock recommendations, analysis, and commentary from stock experts. Take a look free with a 30-day trial.

Robert Brokamp is The Fool's retirement expert and advisor on Motley Fool Rule Your Retirement.


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