Extra Dividends, Extra Growth

Despite our receiving a great deal of positive feedback from folks who like the name of our dividend-oriented newsletter, Motley Fool Income Investor, it seems that some readers are slightly confused by the title. The confusion reveals itself in occasional comments I receive, like "I enjoy your writing, but I'm too young to focus on dividends," or "I like the idea of dividend-paying stocks, but I don't need the income offered by your newsletter."

So, let's clarify a few things about the focus of this service and the purpose of a dividend-oriented investment strategy. Though I've said it before, I can't say it enough: Dividend investing is not age-specific, nor do most people who invest in dividend stocks require the income. Just to be clear, income is simply an additional benefit of the dividend strategy, not its sole purpose.

Investing against the grain
Many people perceive dividend-paying stocks as boring investments with low growth potential, or they think that such stocks are meant exclusively for investors approaching retirement. Even though there's every reason that your father or grandfather should own these stocks, too, nothing could be further from the truth that they should be the only ones interested.

Numerous detailed studies have determined that, over the long term, the stocks of companies that pay dividends tend to outperform the stocks of those that don't. They also tend to outperform the S&P 500. Even better, they do this while generating far less volatility than their stingy competitors, and that means there's a greater chance that your money will be there when you need it.

So, while income is certainly a benefit, a dividend strategy is -- at its core -- nothing more than an excellent screening tool for producing a pool of low-risk companies with market-beating potential.

That's why I usually refer to this method of investing as "the ability to have your cake and eat it if you want to." If you happen to be watching your figure at the moment and you choose to save your cake for later, that's fine, too -- and it's easily accomplished through dividend reinvestment or holding your dividend payers in tax-advantaged accounts. Certainly, even among dividend stocks, one must still choose his or her investments wisely (that is, Foolishly), but this criterion can be a very good place to start.

The forgotten art
According to the Financial Analysts Journal, dividend-payout ratios have been in the bottom 10% of the historical range since 1995. As you might suspect, they reached unprecedented lows during the height of the market bubble -- from late 1999 to mid-2001 -- before recovering somewhat over the past few years.

Many think that it's better for companies to retain all of their earnings because they assume that the company can reinvest them more profitably than they, the stockholders, can. However, if that were true, non-dividend-paying companies would outperform dividend payers. But again, the data does not support this. Indeed, it appears that a given company's decision to pay a dividend -- or increase it -- is, historically, a much more reliable indicator of management's confidence in future earnings than is the decision to retain profits.

Though many firms out there have excellent management, I think we've seen enough to know that putting too much faith in a manager's benevolence is unwise. Even many quality managers' interests are not always aligned with those of shareholders, and that can lead to destruction of capital.

To forgo dividends entirely is to effectively take a leap of faith that management will always act in shareholders' best interests and not engage in undesirable practices, such as compensating itself excessively or engaging in empire-building via dilutive acquisitions.

Given the recent resurgence in the popularity of dividend-paying stocks -- a resurgence that has likely resulted from reduced faith in management to honestly and effectively deploy capital, as well as favorable tax cuts and the poor performance of many non-dividend payers -- I believe the dividend is once again becoming an important component of the individual investor's decision-making process. This, coupled with the likelihood of below-average overall stock market returns in the years to come, bodes well for a dividend-focused strategy because it means that dividends will play a larger role in total returns.

The results
The average dividend yield of my Income Investor recommendations is 4.55%, or three times that of the S&P 500. These picks have also experienced just half the volatility of the overall market.

But, of course, you have to sacrifice growth to get those kinds of results, right? Not so fast. Despite our stodgy dividend focus, our service has managed to generate a total return nearly two times greater than that of the S&P 500. Further, 21 of our 30 recommendations have produced double-digit returns, with 12 of those generating a total return of more than 20% and six of them returning more than 30%. Consistency is another benefit of our approach, with 26 of our 30 selections outperforming the S&P.

Believe me, friends, when I say that the dividend is back, and we don't have to sacrifice a thing to hail its return. Our general target company will have a dividend yield approaching 3%. That's a fairly high benchmark to achieve in today's market, but this target tends to lead us to better values that also have better growth potential. Another beauty of the strategy is that you'll get paid to wait for the market to realize those values. If the price remains low, you'll simply have an opportunity to reinvest your dividends at that low price, or you may choose to cash in on your 3% as needed.

Though this target would currently exclude a fantastic company such as PepsiCo (NYSE: PEP  ) -- with its current yield of 1.8% -- from becoming a core recommendation, it also keeps us from paying too much for proven winners. Indeed, I never lose faith that the PepsiCos or Wal-Marts (NYSE: WMT  ) of the world will one day find their way into the pages of Income Investor, as firms fall into the market's "forgotten list" for one reason or another. And that's when the real dividend values come out to play. After all, if we can snatch up shares of such proven companies as RPM International (NYSE: RPM  ) and Sara Lee (NYSE: SLE  ) -- which have generated total returns for our subscribers of 33.7% and 21.9%, respectively -- when they're yielding nearly 4%, then the PepsiCos and the Johnson & Johnsons (NYSE: JNJ  ) are certainly in the realm of possibility.

The Foolish bottom line
I'm not trying to make dividend investing cool here. In fact, I'd prefer that it remain decidedly uncool, since that perception creates more chances for us dividend lovers to find market-beating companies that also pay out the cabbage.

I'm also not suggesting that every company in your arsenal pay a dividend -- there are many fine companies that don't. However, I would say that as these companies continue their track records of success, many of them are likely to become dividend payers in their own right.

Frankly, what some call maturity, I call stability -- as exemplified by the recent news of a dividend increase and a one-time payout at Microsoft (Nasdaq: MSFT  ) -- and I believe plenty of investors will find dividend investing both stable and rewarding.

Fool on!

This article was originally published on Sept. 13, 2004. It has been updated.

In addition to picking winning dividend stocks, Mathew Emmert can drink a glass of water while standing on his head. You never would have guessed, but he is chief analyst ofMotley Fool Income Investor. He owns shares of PepsiCo, RPM International, and Microsoft. The Motley Fool has a disclosure policy.


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