The Path to Dividends

In my last two articles, I established that dividend-paying stocks not only represent a better investment option than long-term bonds in today's market but that they also outperform other stocks over time. The latter is one that's so oft forgotten that it bears repeating: Dividend stocks outperform. But though it's as simple as that, investor after investor forgets this fact to their pain, to their suffering, and to their strife.

Investing should be enjoyable, yet it's frightening for many. Why? In most cases I believe much of this fear results from a fundamental lack of knowledge about what they're investing in. After all, one can only feel good about an investment that has a reasonable chance of success, but how can you know whether this chance exists if you don't truly understand the business in which you're investing?

So many investors were burned in the bubble of the late '90s, but once again they find themselves holding stocks that make semiconductors or networking equipment or bio synthesizers for next-generation pharmaceutical solutions (whatever that means). If even half the people who own shares of Intel (Nasdaq: INTC  ) or Advanced Micro Devices (NYSE: AMD  ) could fully explain the function of a semiconductor, I'd eat my hat.

Getting to know you, getting to know all about you
The fact is that dividend stocks are most likely to be the types of companies that you can understand. These are the firms that make real products and provide real services that create real cash flow. They then pay some of this real cash flow out to real shareholders in the form of real dollars. You can then choose to reinvest those real dollars into additional shares of real company stock or take them down to the grocery store to buy a carton of eggs and make yourself a real omelette or go on a vacation and get yourself a real sunburn.

I think you get the real point here. These companies produce something tangible -- they provide you with something that you can see and feel, and that something is much more difficult to fake than paper gains.

Getting to like you
Much of that could explain why dividend-paying stocks have performed so well over the long term. They've beaten their stingier counterparts over many significant periods in market history, but their outperformance has been most notable in a period when you'd think just the opposite would be true.

Because dividend-paying stocks are often viewed as safer investments, the common perception is that they tend to underperform non-payers in heated markets. While this was true during the Internet-driven craze of the late '90s, it hasn't held true for many other notable periods. In effect, other than the late-'90s plunge, we've been in a very long bull market since 1980, largely driven by interest rates sinking from the then-20% level to just 4% one year ago.

During the period from 1980 to today, the S&P 500 index has jumped from about 100 points to today's figure of just over 1,200 -- more than a 1,000% increase. I'd say that's about as hefty as a bull can get. You've probably heard that statistic before, but what's far less talked about is the fact that -- during that same period -- dividend payers actually outperformed non-payers by more than 2.6% per year.

Now, that may not sound like much, but consider this: If you'd invested $10,000 in dividend-paying stocks in 1980, today you'd have nearly $119,000 more than your dividend-shunning neighbor (i.e., your $278,004 vs. their $159,105). I'll take my dividends with a steaming-hot spoonful of outperformance, please.

Getting to hope you like me
OK, I know what you're thinking at this point. "That's all well and good, Mathew, but today you're supposed to be telling me how I can actually find these dividend-paying divas myself. I get that dividends rule, but it seems like every time I pick a stock based on its dividend yield, that sucker gets cut down to nothing faster than a Peruvian rain forest. Whenever I get stuck holding the bag of an Eastman Kodak (NYSE: EK  ) or an Electronic Data Services (NYSE: EDS  ) , I don't feel so happy about investing."

Ah, well said, my friend. Notice I never said that this method of investing was an autopilot strategy. You still have to do some research in this arena (shameless plug: unless you want me to do it for you) as a high yield is not always a good yield. Indeed, some of the highest-yielding stocks exist only because their prices have fallen through the floor (i.e., as the stock price falls, the dividend yield rises).

To that end, we've got to do our homework, and here's how to hit the books. The best place to start is cash (yes, cash). After all, that's what we're interested in as dividend investors. We want companies that generate extremely large free cash flows (FCF) that they can then use to reinvest in the business, buy back stock, and pay out as dividends.

You're going to have a good time with this one in today's market, as there is a lot of cash out there right now. U.S. corporate earnings have been on a tear since pulling out of their nosedive three years ago. As a result, many corporate treasure chests are overflowing with cash. According to Standard & Poor's, the aggregate cash on the balance sheet of companies in the S&P 500 stood at about $600 billion near the end of last year. That's up from about $500 billion at year-end 2003 and a mere $260 billion at the end of 1999.

The result is that companies are reloaded, and they're ready to fire at share buybacks, mergers and acquisitions, and -- you guessed it -- substantially higher dividend payouts. After you check out the cash scene, you've got to be sure your company isn't paying out more than it can handle. In that vein, the payout ratio is a very important consideration, but this statistic varies greatly depending on the class of investment.

For instance, in order to maintain their tax-advantaged status, real estate investment trusts (REITs) such as Equity Office Properties (NYSE: EOP  ) are required to pay out 90% of their earnings in the form of dividends, so it isn't uncommon to see solid REITs that pay out as much as 85% of their funds from operations (FFO) (i.e., the cash flow that they generate from their real estate portfolios). Unfortunately, though a popular REIT, Equity Office Properties isn't one of these, as its payout ratio has inched into very negative territory over the past year. Such growth stocks as Coca-Cola (NYSE: KO  ) or General Electric (NYSE: GE  ) , on the other hand, might pay out as little as 15% to 30% of their FCF.

Then there are the generous dividend payers in the banking and utility arenas, such as Citigroup (NYSE: C  ) and Income Investor pick Southern Company (NYSE: SO  ) , which often have a payout ratio in the 50%-75% range.

So, as you can see, there's no magic number that's appropriate for all companies. Of course, the lower the better, but as a general rule I would seek the following:

  • REITs with an FFO payout ratio below 85%
  • Higher growth common stocks that pay out less than 50% of FCF
  • Banks that pay out less than 60% of FCF
  • Regulated utilities that pay out less than 80% of FCF

The Foolish bottom line
Of course, there are many other criteria that I use to screen the selections that make it into my dividend newsletter, Motley Fool Income Investor, such as exactly where the company's cash is coming from (e.g. operations or borrowings), the quality of its management team, a material yield, and a reliable dividend track record. Let's save those for another day. Until next time, my dividend converts.

Fool on!

In addition to picking winning dividend stocks forMotley Fool Income Investor, Mathew Emmert can whistle half the songs in "The King and I" and hum the other half. He owns shares of GE. The Fool has adisclosure policy.


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